Can You Have Income From Life Insurance?

 

I was looking at a recent case wondering: why did this even get to court?

Let’s talk about life insurance.

The tax consequences of life insurance are mostly straightforward:

(1) Receiving life insurance proceeds (that is, someone dies) is generally not an income-taxable event.

(2) Permanent insurance accumulates reserves (that is, cash value) inside the policy. The accumulation is generally not an income-taxable event.

(3) Borrowing against the cash value of a (permanent) insurance policy is generally not an income-taxable event.

Did you notice the word “generally?” This is tax, and almost everything has an exception, if not also an exception to the exception.

Let’s talk about an exception having to do with permanent life insurance.

Let’s time travel back to 1980. Believe it or not, the prime interest rate reached 21.5% late that year. It was one of the issues that brought Ronald Reagan into the White House.

Some clever people at life insurance companies thought they found a way to leverage those rates to help them market insurance:

(1)  Peg the accumulation of cash value to that interest rate somehow.

(2)  Hyperdrive the buildup of cash value by overfunding the policy, meaning that one pays in more than needed to cover the actual life insurance risk. The excess would spill over into cash value, which of course would earn that crazy interest rate.

(3)  Remind customers that they could borrow against the cash value. Money makes money, and they could borrow that money tax-free. Sweet.

(4)  Educate customers that – if one were to die with loans against the policy – there generally would be no income tax consequence. There may be a smaller insurance check (because the insurance is diverted to pay off the loan), but the customer had the use of the cash while alive. All in all, not a bad result – except for the dying thing, of course.

You know who also reads these ads?

The IRS.

And Congress.

Neither were amused by this. The insurance whiz kids were using insurance to mimic a tax shelter.

Congress introduced “modified endowment contracts” into the tax Code. The acronym is pronounced “meck.”

The definition of a MEC can be confusing, so let’s try an example:

(1)  You are age 48 and in good health.

(2)  You buy $4,000,000 of permanent life insurance.  

(3)  You anticipate working seven more years.

(4)  You ask the insurance company what your annual premiums would be to pay off the policy over your seven-year window.

(5)  The company gives you that number.

(6)  You put more than that into the policy over the first seven years.

I used seven years intentionally, as a MEC has something called a “7 pay test.” Congress did not want insurance to morph into an investment, which one could do by stuffing extra dollars into the policy. To combat that, Congress introduced a mathematical hurdle, and the number seven is baked into that hurdle.     

If you have a MEC, then the following bad things happen:

(1) Any distributions or loans on the policy will be immediately taxable to the extent of accumulated earnings in the policy.

(2) That taxable amount will also be subject to a 10% penalty if one is younger than age 59 ½.

Congress is not saying you cannot MEC. What it is saying is that you will have to pay income tax when you take monies (distribution, loan, whatever) out of that MEC.

Let’s get back to normal, vanilla life insurance.

Let’s talk about Robert Doggart.

Doggart had two life insurance contracts with Prudential Insurance. He took out loans against the two policies, using their cash value as collateral.

Yep. Happens every day.

In 2017 he stopped paying premiums.

This might work if the earnings on the cash value can cover the premiums, at least for a while. Most of the time that does not happen, and the policy soon burns out.

Doggart’s policies burned out.

But there was a tax problem. Doggart had borrowed against the policies. The insurance company now had loans with no collateral, and those loans were uncollectible.   

You know there is a 1099 form for this.

Doggart did not report these 1099s in his 2017 income. The IRS easily caught this via computer matching.

Doggart argued that he did not have income. He had not received any cash, for example.

The Court reminded him that he received cash when he took out the loans.

Doggart then argued that income – if income there be - should have been reported in the year he took out the loans.

The Court reminded him that loans are not considered income, as one is obligated to repay. Good thing, too, as any other answer would immediately shut down the mortgage industry.  

The Court found that Doggart had income.

The outcome was never in doubt.

But why did Doggart allow the policies to lapse in 2017?

Because Doggart was in prison.

Our case this time was Doggart v Commissioner, T.C. Summary Opinion 2023-25.

Chapter 7 Bankruptcy and Taxes

It was one of the last individual tax returns I saw this year going into October 15, so the topic is on my mind.

The topic is bankruptcy. It seems that I have seen or discussed bankruptcy more in the last three years than in the balance of my career years combined. There are peculiar tax rules to bankruptcy. Today I want to talk about chapter 7, also known as liquidation, as that is the type of bankruptcy that I have been seeing the most.

Chapter 7 is the classic bankruptcy. Your assets and liabilities pass to the bankruptcy trustee. The trustee sells what he/she can and pays what is possible to the creditors. When done the judge discharges the bankruptcy and one is free of all debts. Depending on the state you may retain certain types of assets. The example I am familiar with is the primary residence in Florida. Some debts may follow you out of bankruptcy. An example is the loan on your car. You reaffirm the debt because you want, or need, to keep the car. If you want the car you have to keep the debt.

Upon filing a Chapter 7, your assets and liabilities past to the bankruptcy estate, which is normally represented by a trustee. It may be that some assets do not pass, but let’s not include that issue in our discussion. The estate also succeeds to one’s tax attributes. Think of attributes as tax benefits waiting to happen: a net operating loss or a general business tax credit, for example. When they finally kick-in, there is a benefit – meaning a reduction in tax – to you.

Why is this important? Because the estate is a separate taxpaying entity. When calculating its tax, the trustee can use your tax attributes to offset the estate’s tax. So, if you have an NOL, the trustee can use it to offset the estate’s taxable income. When you remember that the NOL can only be used once, this has meaning to you. If the trustee uses it, then you cannot.

There is another important tax consideration to bankruptcy. You may already know that debt discharged in bankruptcy is not taxable to you. Did you know, however, that you have to reduce your tax attributes to the extent that you have discharged debt? If you have $56,000 of debt discharged and have a $61,000 NOL carryforward, you have to reduce that NOL carryforward to $5,000 ($61,000 – 56,000).

What is the estate taxed on? Remember that one’s assets move to the estate upon filing Chapter 7. If the income can be traced to the asset, then the income is taxable to the estate as long as the asset is inside the estate. Examples include:

·         Dividends on stocks

·         Interest on bonds

·         Royalties on mineral rights or patents

·         Rental income on rental real estate

·         Capital gains or losses from selling stocks and bonds

What is not taxable to the estate? The classic example is your paycheck. It cannot be traced to an asset inside the estate, so it is not taxable to the estate. It is however taxed to you.

So the estate files a tax return for interest and dividends. You file a tax return for your wages. You now have two tax returns where there used to be just one.

And that is how the estate uses up your tax attributes. When the estate is discharged, it should tell you what is left on the tax attributes, because now you can use what is left. There may be nothing left.

This works well if the estate is large enough to have its own tax return. Frankly, what I have seen in recent years (at least the last 5 years) are small bankruptcy estates. These estates generally do not file a separate estate return, although technically they are supposed to. Rather all the estate numbers (think dividends and the sale of the stock that generated them) are combined with the taxpayer’s other non-bankruptcy numbers (think W-2) and reported on taxpayer’s individual income tax return. Now it becomes important for the CPA to remember the tax attribute rule, because there is no separate estate return to remind him/her.

This past weekend I met with a client who had $79,901 discharged in Chapter 7. There was no separate bankruptcy estate tax return. We did not make an election to end the client’s tax year upon the date of the Chapter 7 filing. She did have tax attributes to reduce. The client’s tax consequence went as follows:

                Debt discharged                                              79,901

                Net operating loss carryover                     ( 43,268)

                Capital loss carryover                                   ( 11,045)

                                                                                              25,588

                Note receivable                                              ( 25,588)

                                                                                                    -0-

The client lost the NOL and capital loss carryovers to the debt discharge. The amount left over reduced the client’s basis in a note receivable from a partnership. Think about this for a moment. What happens when our client is repaid the note in the future? Our client would receive more money than the client has basis in the note. Is this a taxable event? You bet. Why did we select the note? Because the note is in a partnership that is unlikely to ever repay our client in full. We considered the risk of the “phantom income” to be slight.

The IRS does not intend for bankruptcy to be “free.” From a tax perspective, what the IRS wants is for the bankruptcy to be tax-neutral over a period of time. In the above example, our client was not taxed on the $79,901, but the IRS has immediately eliminated $54,313 of tax benefits. The IRS further hopes that our client is repaid the note in full, because that will trigger $25,588 of phantom income. At that point $54,313 + 25,588 equals $79,901, which was the discharged income the IRS did not tax. To the IRS this would constitute a “push,” as it was out only the time value of the tax but not the tax itself.

Is there an order how the tax attributes are to be used up? Of course. The order is as follows:

·         Net operating loss carryover

·         General business credit carryover

·         Minimum tax credit carryover

·         Capital loss carryover

·         Basis of property

·         Passive activity loss and credit carryovers

·         Foreign tax credit carryover

There are other types of bankruptcy than Chapter 7. There is Chapter 13, which is a reorganization of debt for an individual. Chapter 12 is for farmers and Chapter 11 is for businesses. Perhaps we will talk about them – on another day.