A Surprise Tax From Life Insurance Loans

 

For some reason, the taxability of life insurance seems to be an old reliable in tax controversy.

Granted, there are areas involving life insurance that are not intuitive. The taxation of a split-dollar life insurance policy to an employee can be a bit puzzling until you have studied it one or ten times. There is also the tax history of “janitors insurance,” which resulted in yet another tax acronym (“EOLI”), the creation of Form 8925, and the recurring question “what is the purpose of this form” from young tax accountants ever since.

 

No, what we are talking about is the income taxation of vanilla-ice cream-on-a-regular-cone life insurance. Life insurance is normally nontaxable. You can change that answer by not ordering vanilla.

David and Cindy Fugler bought permanent (that is, cash value) life insurance on their two children in 1987. There was the initial year payment, plus additional yearly premiums, some of which were paid by borrowing against the policies. After many years, they cashed-in the policies. The life insurance company sent Forms 1099, which the Fuglers did not report on their joint tax return.

COMMENT: As we have discussed before, the IRS loves to trace Forms 1099 to tax returns, as the process can be computerized and requires no IRS manpower. You, on the other hand, have no such luck and will likely contact your tax preparer/advisor – and incur a fee - to make sense of the notice. There you have current tax administration in a nutshell: increasingly shift compliance to taxpayers by requiring almost everything to be reported on a 1099. It is a brilliant if not cynical way to increase taxes without – you know – actually increasing taxes.

Here is a recap of the relevant Fugler numbers:      

		Policy #1		Policy #2
Cumulative premiums paid		6,850		6,850
Accumulated cash value		22,878		23,428
Outstanding loan & interest		(19,845)		(20,699)
Settlement check		3,033		2,729

 

On first impression, it might seem odd that the Fuglers did not report the two distribution checks: the $3,033 and the $2,729. This is the amount they received upon policy cancelation – and after repaying policy loans and related interest and whatnot charges. Then again, one does not normally expect to have taxable income from life insurance. One should still report the 1099 amount (so the IRS computers have something to latch onto) and thereafter adjust the numbers to what one considers correct. Without that latch, these IRS matching notices are automatic.

So, what do you think:

·      Do the Fuglers have income?

·      If so, what is the income amount?

To reason through this, think of the life insurance policies as savings accounts. Granted, inefficient savings accounts, but the tax reasoning is similar. If you put in $6,850 and years later receive $22,878, the difference is likely (some type of) income. The same reasoning applies to the second policy.

So, you have income. Is there some way to not have income? Sure, if the cumulative premiums you paid exceed any cash value. In that case any refund would be a return of your own money.

But what is the income amount: is it the checks they received: $3,033 (for policy #1) and $2,729 (for policy #2)?

Normally, this would be correct, but the Fuglers borrowed against the polices. The loan did not create income at the time (because of the obligation to repay). That obligation has now been repaid with cash that would otherwise have been included in those distribution checks. You cannot avoid income by having a check go directly to your lender. Tax advisors would have a field day if only that were possible.

I would say that the income amount is the cash received plus the loan forgiven: $16,028 (policy #1) and $16,578 (policy #2).

Before thinking the result unfair, remember that the Fuglers did receive the underlying cash. The timing for the taxation of the loan was delayed, but even that result was pro-taxpayer. This is not phantom income that we sometimes see in other areas of the Code.

There is some chop in the numbers for the loan forgiven. As you can imagine, there are all kinds of fees and charges in there, as well as possibly accrued interest on the loan.  The Fuglers thought of that also, arguing that the accrued interest should not be taxable – or at least should be deductible.

The “should not be taxable” is a losing argument, as all income is taxable unless the Code says otherwise. It does not, in this case.

That leaves a possible interest deduction.

The problem here is that Congress limited the type of nonbusiness loans whose interest is deductible: loans on a principal residence; loans used to buy or carry investments, college loans; loans (starting in 2026) on a new car with final assembly in the United States. Any other nonbusiness loans are considered personal, meaning the interest thereon is also personal and thus nondeductible.

The Fuglers could not fit into any of those deductible categories. There was no subtraction for interest, no matter what the insurance company called it.

The Fuglers had taxable income. They reported none of it on their return. The IRS – as usual – wanted interest and penalties and whatever else they could get.

The Tax Court agreed.

Our case this time was Fugler v Commissioner, T.C. Summary Opinion 2025-10.

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.

Do Not Do This When Buying Disability Insurance

 

It is a tax trap. An employer thinks that they are doing a boon for their employees by providing a tax-exempt fringe benefit.

Where is the trap?

CTG: it has to do with insurance.

I don’t get it, you say. My employer pays for some/most/all my health insurance. When I see a doctor, the insurance pays some, I pay some. Granted, some health insurances are better than others, but where is the trap?

CTG: it is not health insurance.

I get life insurance at work, you continue. It is equal to a year’s salary or something like that. I have noticed that they charge me something for this on my W-2 every year.

CTG: Life insurance has a split personality. An employer can offer you up to $50 thousand of life insurance as a nontaxable fringe. Any insurance above that amount (for example, if your annual salary is more than $50 grand) is taxable to you. Mind you, the charge tends to be minimal - as the IRS uses favorable rates - but you are charged something.  

It is not life insurance.

It is disability insurance.

Let’s look at John Linford.

John sold Medicare supplement and Medicare Advantage plans. His employer decided to do a nice, and in 2011 it purchased a group disability policy from Principal Life. On the plan’s first iteration, the company paid 100% of the premiums. In 2013 the plan was amended, giving the company the option to charge an employee 25% of the premiums. The company said “nah” to the option, choosing to continue paying 100% of the premiums.

At first blush, this sounds like a beneficent employer.

John incurred a disability in 2014. He filed a worker’s compensation claim in December 2014.

John was fired a year later, in November 2015.

This may still be a beneficent employer. They might have been assisting John in getting to that disability policy.

In May 2017 Principal Life approved his disability claim.

At that speed, one could be homeless before the insurance kicks-in.

Principal Life paid him a $105 grand in retroactive benefits.

John heard that disability is generally nontaxable.

Yep.

John left the $105 grand off his tax return.

Nope.

The IRS caught it, of course.

The IRS wanted almost $22 thousand in tax, as well as a penalty chop of over $4 grand.

Off to Tax Court they went.

There is a Code section for this type of employer-provided insurance: Section 105.

           § 105 Amounts received under accident & health plans.

(a)  Amounts attributable to employer contributions.

Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Read the verbiage at (a).

Except as otherwise provided, any accident or health insurance is taxable to the extent the employer provides the insurance as a tax-free benny. Wait, you say, what about health insurance? That is not taxable. True, but health insurance is nontaxable via the “except as otherwise provided” language. There is no such exception for disability insurance.

This stuff can be confusing.

John had one more swing at the plate. Remember that the company amended the plan allowing them to charge employees 25% of the cost. John wanted to know if there was some relief there. I get it: 25% nontaxable is not as good as 100% nontaxable, but it is better than 100% taxable.

The Court said no. Potential is not actuality, and John never paid any of the premiums.

What about the penalties? Did the Court cut John some slack? One can get confused here: one rule for health insurance, another rule for different insurance.

Based on the record the Court concludes that the petitioner husband did not have reasonable cause and did not act in good faith in not reporting the disability payments.”

The Court upheld the penalties. There went another $4-plus grand.

Some companies allow one to purchase short-term disability through their cafeteria plan. Mind you, this means that the premiums are paid with pre-tax money and will result in taxable income if benefits are ever collected. I tend to back-off on short-term disability, although I prefer that one pay with after-tax dollars for either short- or long-term disability.

I, however, feel strongly about paying after-tax for long-term disability. Those benefits may continue until you reach social security age, and you do not need to be dragging taxes behind you until then. The small rush of a tax-free benny is insignificant if you are ever – in fact – disabled.

Our case this time was Cynthia L Hailstone and John Linford v Commissioner, T.C. Summary Opinion 2023-17.

The Obamacare Subsidy Cliff

 

I am looking at a case involving the premium tax credit.

We are talking about the Affordable Care Act, also known as Obamacare.

Obamacare uses mathematical tripwires in its definitions. That is not surprising, as one must define “affordable,” determine a “subsidy,” and - for our discussion – calculate a subsidy phase-out. Affordable is defined as cost remaining below a certain percentage of household income. Think of someone with extremely high income - Elon Musk, for example. I anticipate that just about everything is affordable to him.

COMMENT: Technically the subsidy is referred to as the “advance premium tax credit.” For brevity, we will call it the subsidy.

There is a particular calculation, however, that is brutal. It is referred to as the “cliff,” and you do not want to be anywhere near it.

One approaches the cliff by receiving the subsidy. Let’s say that your premium would be $1,400 monthly but based on expected income you qualify for a subsidy of $1,000. Based on those numbers your out-of-pocket cost would be $400 a month.

Notice that I used the word “expected.” When determining your 2022 subsidy, for example, you would use your 2022 income. That creates a problem, as you will not know your 2022 income until 2023, when you file your tax return. A rational alternative would be to use the prior year’s (that is, 2021’s) income, but that was a bridge too far for Congress. Instead, you are to estimate your 2022 income. What if you estimate too high or too low? There would be an accounting (that is, a “true up”) when you file your 2022 tax return.

I get it. If you guessed too high, you should have been entitled to a larger subsidy. That true-up would go on your return and increase your refund. Good times.

What if it went the other way, however? You guessed too low and should have received a smaller subsidy. Again, the true-up would go on your tax return. It would reduce your refund. You might even owe. Bad times.

Let’s introduce another concept.

ACA posited that health insurance was affordable if one made enough money. While a priori truth, that generalization was unworkable. “Enough money” was defined as 400% of the poverty level.

Below 400% one could receive a subsidy (of some amount). Above 400% one would receive no subsidy.

Let’s recap:

(1)  One could receive a subsidy if one’s income was below 400% of the poverty level.

(2)  One guessed one’s income when the subsidy amount was initially determined.

(3)  One would true-up the subsidy when filing one’s tax return.

Let’s set the trap:

(1)  You estimated your income too low and received a subsidy.

(2)  Your actual income was above 400% of the poverty level.

(3)  You therefore were not entitled to any subsidy.

Trap: you must repay the excess subsidy.

That 400% - as you can guess – is the cliff we mentioned earlier.

Let’s look at the Powell case.

Robert Powell and Svetlana Iakovenko (the Powells) received a subsidy for 2017.

They also claimed a long-term capital loss deduction of $123,822.

Taking that big loss into account, they thought they were entitled to an additional subsidy of $636.

Problem.

Capital losses do not work that way. Capital losses are allowed to offset capital losses dollar-for-dollar. Once that happens, capital losses can only offset another $3,000 of other income.

COMMENT: That $3,000 limit has been in the tax Code since before I started college. Considering that I am close to 40 years of practice, that number is laughably obsolete.

The IRS caught the error and sent the Powells a notice.

The IRS notice increased their income to over 400% and resulted in a subsidy overpayment of $17,652. The IRS wanted to know how the Powells preferred to repay that amount.

The Powells – understandably stunned – played one of the best gambits I have ever read. Let’s read the instructions to the tax form:

We then turn to the text of Schedule D, line 21, for the 2017 tax year, which states as follows:

         If line 16 is a loss, enter ... the smaller of:

·      The loss on line 16 or

·      $3,000

So?

The Powells pointed out that a loss of $123,822 is (technically) smaller than a loss of $3,000. Following the literal instructions, they were entitled to the $123,822 loss.

It is an incorrect reading, of course, and the Powells did not have a chance of winning. Still, the thinking is so outside-the-box that I give them kudos.

Yep, the Powells went over the cliff. It hurt.

Note that the Powell’s year was 2017.

Let’s go forward.

The American Rescue Plan eliminated any subsidy repayment for 2020.

COVID year. I understand.

The subsidy was reinstated for 2021 and 2022, but there was a twist. The cliff was replaced with a gradual slope; that is, the subsidy would decline as income increased. Yes, you would have to repay, but it would not be that in-your-face 100% repayment because you hit the cliff.

Makes sense.

What about 2023?

Let’s go to new tax law. The ironically named Inflation Reduction Act extended the slope-versus-cliff relief through 2025.

OK.

Congress of course just kicked the can down the road, as the cliff will return in 2026.

Our case this time was Robert Lester Powell and Svetlana Alekseevna Iakovenko v Commissioner, T.C. Summary Opinion 2002-19.