You may know
that permanent life insurance can create a tax trap.
This happens
when the insurance policy builds up cash value. Nice thing about cash value is
that you can borrow against it. If the cash value grows exponentially, you can
borrow against it to fund your lifestyle, all the while not paying any income
tax.
There is
always a "but."
The
"but" is when the policy terminates. If you die, then there is no tax
problem. Many tax practitioners however consider death to be extreme tax
planning, so let's consider what happens should the policy terminate while you
are still alive.
All the
money you borrowed in excess of the premiums you paid will be income to you. It
makes sense if you think of the policy as a savings account. To the extent the balance
exceeds whatever you deposited, you have interest income. Doing the same thing
inside of a life insurance policy does not change the general rule. What it
does do is change the timing: instead of paying taxes annually you will pay
only when a triggering event occurs.
Letting the
policy lapse is a triggering event.
So you would
never let the policy lapse, right?
There is our
problem: the policy will require annual premiums to stay in effect. You can
write a check for the annual premiums, or you can let the insurance company
take it from the cash value. The latter works until you have borrowed all the
cash value. With no cash value left, the insurance company will look for you to
write a check.
Couple this
with the likelihood that this likely will occur many years after you acquired the
policy - meaning that you are older and your premiums are more expensive - and
you can see the trap in its natural environment.
The Mallorys
purchased a single premium variable life insurance policy in 1987 for $87,500.
The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed
to borrow. If he did, he would have to pay interest. The policy allowed him two
ways to do this: (1) he could write a check or (2) have the interest added to
the loan balance instead.
Mallory
borrowed $133,800 over the next 14 years - not including the interest that got
charged to the loan.
Not bad.
The
"but" came in 2011. The policy burned out, and the insurance company
wanted him to write a check for approximately $26,000.
Not a chance
said Mallory.
The
insurance company explained to him that there would be a tax consequence.
Says you said
Mallory.
The policy
terminated and the insurance company sent him a 1099 for approximately
$150,000.
It was now tax time 2012. The Mallorys went to
their tax preparer, who gave them the bad news: a big tax check was due.
Tax preparer
became ex-tax preparer.
The Mallorys
did not file their 2011 tax return until 2013. They omitted the offending $150,000,
but they attached the Form 1099 to their tax return with the following explanation:
Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."
The IRS in
turn replied that they wanted $40,000 in tax, a penalty of approximately
$10,000 for filing the return late and another penalty of over $8,000 for omitting
the 1099 in the first place.
The Mallorys
countered that they had no debt with the insurance company. Whatever they received
were just distributions, and they were under no obligation to pay them back.
In addition,
since they received no cash from the insurance company in 2011, there could not
possibly be any income in 2011.
It was an
outside-the-box argument, I grant you. The problem is that their
argument conflicted with a small mountain of paperwork accumulated over the
years referring to the monies as loans, not to mention the interest on said
loan.
They also
argued for mitigation of the $8,000 penalty because no one could tell them the
taxable portion of the insurance policy.
The Mallorys
had contacted the IRS, who gave them the general answer. It is not routine IRS policy to specifically analyze
insurance company 1099s to determine the taxable amount.
They had
also called random tax professionals asking for free tax advice.
COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.
This is, by the way, why many practitioners simply do not accept calls like this.
The Court
did not buy the Mallory's argument. It was not true that the Mallorys were not
advised: they were advised by their initial tax preparer - the one they unceremoniously
fired. After that point it was a stretch to say that they received advice - as
they never hired anyone. A phone call for free tax advice did not strike the Court
as a professional relationship providing "reasonable cause" to
mitigate the $8,000 penalty.
The Mallorys
lost across the board.
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