January 2023 Volume 19

A Tax Nightmare

Noel Spencer, MBA, LUTCF, EA
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Many taxpayers borrow against their life insurance cash surrender values. In fact, a common strategy is to borrow cash value during your lifetime and then have the insurance company offset the death benefit by the outstanding loan amount when you die.

But when a life insurance policy terminates before death, the cash surrender value is taxable, and the Grim Reaper is looking for tax dollars.

In this case, Northwestern did not send any cash to the Browns because the entire cash surrender value was needed to pay off the loans. In the days of tax shelters, the receipt of taxable income without the receipt of cash was called “phantom income.”

Bruce Brown fell into this life insurance policy loan trap.

Mr. Brown, a commercial litigation attorney, purchased a life insurance policy from a Mutual Life Insurance Company. For the first six and a half years, he paid the insurance premiums by check. For the next 15 1/2 years, he paid the premiums by borrowing at 8 percent interest against the policy’s cash value.

Because of the borrowing, the Year 22 annual interest accrual was twice the insurance premium due. This was a problem.

To mitigate this problem, Mr. Brown surrendered his $31,063.30 of additional paid-up insurance that he had earned over the 21 previous years by investing his policy dividends to buy additional paid-up insurance.

Unfortunately, his surrender of the additional paid-up insurance did not cure Mr. Brown’s problem. The surrender simply reduced both the policy debt and the cash value of the policy. Thus, after the surrender, Mr. Brown continued to have policy debt in excess of the cash surrender value.

At the end of year 24, the insurance company terminated the policy because the policy debt exceeded the cash surrender value, and Mr. Brown’s tax nightmare began.

Tax Nightmare

The insurance company sent Mr. Brown a Form 1099-R that described $37,365.06 as loans repaid at surrender and reported $29,093.30 as the taxable amount at surrender.

Mr. Brown and his wife who has her master of laws degree (LL.M.) in taxation, believed that they received the 1099-R in error, and they did not report the $29,093.30 as taxable income.

Not reporting 1099 income is a mistake. It drives the IRS computers nuts because they cannot match the 1099 to the tax return.

The IRS assessed the tax that would have been due had the $29,093.30 been included in the tax return. The Browns disputed the tax and took their case to court, where they lost and also were tagged with a 20 percent penalty for substantial understatement of taxes.1

The Full Story


As noted by the court, here is how the Northwestern policy worked in the Browns’ case:

Monies Earned by the Policy:
Surrender value at termination used to pay loans


Surrender value from paid-up insurance used to pay loans


Dividend payment to Mr. Brown


Dividend payment to Mr. Brown


Total monies earned and paid out to Mr. Brown


Monies Invested in the Policy
Policy premiums paid by loans


Policy premiums paid by checks


Policy premiums paid by applying dividends to premiums


Total Investment in Policy


Taxable Income at Termination


Note that most of the action on this life insurance policy took place inside the policy itself. Mr. Brown saw very little cash.


Take a look at the cash values in your insurance policies, including those that cover your children. Are you using cash values to pay the premiums?

If so, are you creating a tax liability upon termination of the policy? If yes, is it possible that the insurance company will terminate your policy and trigger taxable income to you? If so, start your tax planning now to offset this taxable income or put aside the money you need to pay the taxes.

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