Monday, January 31, 2011

A Sad Life Insurance Story

John M. Sanders v. Commissioner, TC Memo 2010-279

I've mentioned in a previous post that life insurance has some marvelous income tax benefits.  The build-up in value is tax deferred and becomes income tax free if it is paid by reason of the death of the insured.  Life insurance salesmen will sometimes claim it saves estate taxes.  This is a bit of a fallacy.  The estate tax savings come from having the insurance owned outside the decedent's estate.  Any appreciating asset would produce the same benefit.  Life insurance does have the merit of providing liquidity exactly when it is needed in some estate plans.  It all kind of makes me feel bad for Mr. Sanders who managed to figure out a way to manufacture taxable income for himself without the cash to pay the taxes.

Mr. Sanders had a $25,000 life insurance policy with New York Life.  He paid $31 per month on the policy from 1979 to 2006.  Between 1990 and 2004 he borrowed $7,136 on the policy.  Under the terms of the policy, interest on loans accrued at 8%. In 2006 he received a letter that the loan amount and accumulated interest was $17,203, which was $517 more than the policy's surrender value.  Unless he paid $517 the policy would be cancelled.  He didn't pay the $517 so his policy was cancelled.

He received a 1099-R from New York Life showing a distribution of $17,292.  The taxable amount was $7,175.  That is the gross distribution of $17,292 less premiums of $10,117.  Mr. Sanders found the whole thing a little confusing :

Petitioner testified that he disagrees with the taxable amount shown on the Form 1099-R because he “just did the math basically in my head” and he thinks New York Life's “mathematics are way off.”

The Tax Court didn't find much merit in his argument.

These vague contentions do not rise to the level of a “reasonable dispute” so as to impose any burden of production on respondent pursuant to section 6201(d). In any event, stipulated documentation of petitioner's premium and loan history with New York Life corroborates the information reported on the Form 1099-R.

I have a lot of sympathy for Mr. Sanders.  He paid $10,117 to an insurance company.  He drew out $7,136.  It appears coincidental that the amounts are so close, but he ended up being taxed on the entire withdrawal plus $39.  Of course he had the peace of mind that somebody would be getting $25,000 less the outstanding loan balance in the event of his death.  According to standard valuation tables that comfort would be worth less than $25 a year until Mr. Sanders was in his forties.  We can't tell from the case how old he was when he started the policy so I don't think I will go any further with that part of the analysis.

A key fact that does not receive much emphasis is:

Between 1990 and 2004 petitioner borrowed $7,136 against the policy. Insofar as he recalls, he used the proceeds for personal purposes.

So the interest that he wasn't paying was "personal interest" and not deductible.  When he constructively paid it with a deemed distribution of the cash surrender value of his policy, there was not an offsetting deduction.   He had taxable income because he didn't pay the interest he incurred for borrowing his own money.  Go figure. This was probably not the outcome that Mr. Sanders expected when he started dutifully paying his $31 per month while we were all worrying about the hostages and cursing the Ayatollah.  I hope somebody from New York Life expressed some sympathy.


  1. Hi,
    Wow thank you for such an amazing piece of work. It makes a lovely change to read something that is inspirational. I was looking through to find people with similar interests and I came upon your work. I have an interest in Human Rights and I am very proactive in this area especially in the Tibetan cause. I would very much like to follow your blog and would apreciate if you could check out mine even though it is a little different from your own,

    Thanks Tenzin Dasal

  2. But if John had NOT borrowed the $7136 from the policy the cash value would have been the same $17,292 and his gain on surrender (after subtrating his cost basis of $10,117) would be the exact same $7175! Obviously the taxable amount is not the issue here. (also note that the loan itself was not taxed when he received it, but since he never paid it back the loan plus interest reduced his cost basis).
    The problem is that, due to the interest accrued on the outstanding loan, there isn't any net cash value available to pay the tax that is rightly due.
    But this is simply a cost of the use of the money issue. Had John invested the $7136 loan at 6.53%/yr then he would have the same $17,292 and the funds to pay the taxes. If he choose not to invest it, but spend it for current consumption then the interest cost is the oppurtunity cost for that purchase- the same as with every other dollar spent vs saved.
    This is everyday math and basic finance that really doesn't have anything to do with the insurance policy, which is why the court correctly ruled that the tax is owed! If he didn't understand how loans work then he should have consulted with his CPA before taking out the loan- the insurance company does not give tax advice.

  3. I agree that the problem was the interest. I still think he got screwed. He was accumulating 8% interest to borrow his own money. It is similar to the pass book loan phenomenon. By putting the money into a policy he was creating a situation where it was being credited at one rate while he was being charged at another rate. Those policies were sold not bought as a one stop solution to all your financial needs. The possibility of this scenario was probably not emphasized on the front end.

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