Given all the misery, suffering and injustice in the world, I guess people getting a tax screwing because of whole life insurance is not the worst thing that can happen. According to Just Detention International over 200,000 prisoners are sexually assaulted in the United States each year. That's a lot worse. Still, I'm a tax blogger, so I write about the bad tax things that happen to people. I find it particularly galling when something that is meant to be tax beneficial turns into a tax nightmare. It seems to happen a lot with whole life insurance. The latest I've noted is the case of Boyd J. Black.
Mr. Black was in Tax Court over a deficiency notice of $30,571 in tax and an accuracy-related penalty of $6,114 for the year 2009.
Here is how it happened. Mr. Black had taken out a life insurance policy with Northwestern Mutual Life. The policy allowed him to borrow up to the cash surrender value. Unpaid interest on the cash surrender value would be added to the loan. At any time, he could surrender the policy and receive the cash surrender value net of the loan balance, including accumulated interest. Mr. Black took advantage of the loan feature borrowing $103,548 over time and made no payments on the loan or the interest. The total balance grew to $196,230.
In January 2009, the policy terminated. Mr. Black received a 1099 for $196,230. Presumably the loan balance caught up with the cash surrender value, which is bound to happen if you don't put any money in, unless you die. Since his investment in the contract was $86,663, by IRS reckoning, he is taxed on $109,567. On his initial return, Mr. Black reported no income from the insurance policy termination. He did not acknowledge on his return the Form 1099-R. In the summer of 2011, he filed an amended return which increased his income by $16,885, the amount by which his borrowings exceeded his investment in the policy. The IRS appears not to have processed the amended return, although the attached check for $4,775 was cashed.
I have a lot of sympathy for Mr. Black's perspective. He put about $87,000 into the policy and took out about $103,000, so he should pay tax on about $17,000. When he took the policy out in 1979, most interest was deductible, so the extra return of about $90,000 would have more or less been washed by an interest deduction. Except for the Tax Reform Act of 1986 which eliminated many interest deductions. Thanks to that change, Mr. Black ends up with $30,000 in tax generated by phantom income from borrowing his own money.
As with the great majority of these cases, the Tax Court ruled in favor of the IRS including upholding the accuracy penalty. The only case I have ever seen that has been a taxpayer victory was that Jeffrey J. Furnish. Mr. Furnish is an actuary and he poked holes in the numbers that Northwestern used to compute his taxable distribution. (I note in passing that Northwestern seems to have more than its fair share of these cases) That shifted the burden of proof to the IRS, a burden they could not carry.
What Should People Do?
One thing that you should do is have your life insurance policy serviced by a qualified agent, who won't let you get blindsided like this. It is probably not that great an idea to use a policy that you want to stay in force as a liquidity source. If you are upside down maybe, there is a way to keep the policy alive. You can't tell from the case what the face of the policy and the spread between the dividend and borrowing rate were.
If that horse is already out of the barn, it is also clear that you should not just ignore the 1099 that the insurance company sends. If you want to take an aggressive position on the taxable amount of the distribution, which I hesitate to recommend, take it on the original return showing the gross amount in the proper place. I know I am bordering on audit lottery advice here, but you are not my client.
If the numbers are substantial, you may want to see if you can figure out how to replicate Mr. Furnish's victory. If you get someone with expertise to poke holes in the insurance company's numbers, Mr. Furnish's victory might give you a lot of leverage at appeals.