Category: Miscellaneous
Subject: Life Insurance Loans
Title: Various Issues
IRC Sections: 72(e)(5)(E), 72(e)(5)(A), 72(e)(6); 101
Filename: 1107.html
Date Produced: 3/97 Copyright 1998, The Tax Resource Group. All rights reserved. Telephone
800-578-3498. Internet: www.taxresourcegroup.com Background
Taxpayer is currently 75 years of age. In 1986, he purchased a single premium
life insurance policy with a face amount of $25,000. The policy now has
a cash surrender value of $50,100 and is encumbered by a policy loan of
$43,000. The loan amounts were taken out over the past five-to-seven years.
When the taxpayer reaches age 95, the policy matures/expires. Presumably,
at that time he will receive any cash surrender value in excess of outstanding
policy loans. Questions
1. Are the loans taxable in whole or in part?
2. What are the income tax implications when the taxpayer dies?
3. What is the tax effect when the policy matures/expires?
4. What happens if the taxpayer donates the policy to a charitable organization? Answers
1. The policy loans are wholly nontaxable.
2. When the taxpayer dies, receipt of the proceeds from the policy are wholly
excludable from income.
3. Amounts received on maturity of the contract are taxable to the extent
such amounts exceed the taxpayer's investment in the contract.
4. Donation of the policy to a charitable organization is a partially taxable
event that effectively triggers partial taxation of the inside build-up
in the policy. Discussion: Questions 1 and 3
In general, an amount withdrawn from an annuity, endowment, or life insurance
contract prior to the starting date of the annuity is potentially taxable.
The issue when such amounts are withdrawn is, in effect, what is the taxpayer
withdrawing first, his investment in the contract or the accumulated income?
For contracts entered into prior to August 14, 1982, taxpayers were allowed
to first recover the cost of the annuity contract prior to recognizing any
of its accumulated income. The Tax Equity and Fiscal Responsibility Act
of 1982 (TEFRA) changed the rule for contracts entered into after August
13, 1982. For these contracts, withdrawals come first from accumulated income
and then from the taxpayer's investment in the contract. Prior to TEFRA, a loan against an annuity, endowment, or life insurance
contract was treated as a bona fide loan from a third party lender, not
as a distribution under the contract. See Minnis v Commissioner, 71 TC 1049
(1979), nonacq 1979-2 CB 2; and Drake v US, 597 F Supp 1271 (DNC 1984),
85-1 USTC ¶9146, 55 AFTR2d 85-823. The IRS had taken a contrary position
in Revenue Ruling 81-126, 1981-1 CB 206 and did not take kindly to its loss
in the Minnis and Drake, supra. The IRS managed to persuade Congress to
change the rules in 1982 to provide that loans do constitute distributions
from the contract as a matter of law. See IRC Section 72(e)(4). However,
the life insurance industry was successful in preserving the pre-1982 rules
for life insurance and endowment contracts. Following is an except from
the Committee Reports on P.L. 97-248 (Tax Equity and Fiscal Responsibility
Act of 1982).
The Senate amendment provides that amounts received before the annuity starting
date will be treated first as withdrawals of income earned on investments
to the extent of such income, the remainder being treated as a return of
capital. Likewise, loans under the contract, or amounts received upon assignment
or pledging of the contract, will be treated as amounts received under the
contract. These provisions apply as of July 1, 1982, but do not apply to
income amounts allocable to investments made before July 2, 1982, to endowment
or life insurance contracts (except to the extent prescribed in regulations),
or to contracts purchased under qualified pension plans. [Emphasis supplied.] The rules were modified again in 1988 to apply the post-1982 distribution
provisions to so-called modified investment contracts entered into after
June 21, 1988. I strongly suspect that the taxpayer's life insurance policy
would be a modified endowment contract but for the fact that he purchased
the policy before the effective date of this provision. It seems to me the bottom line with respect to policy loans for the life
insurance contract in question is that loans do not represent taxable withdrawals
from the contract. On the other hand, I think maturity of the policy gives rise to taxable
income to the extent the amount received (not reduced by the loan against
the policy) exceeds the taxpayer's investment in the life insurance contract.
See IRC Sections 72(e)(5)(E) and 72(e)(5)(A), flush language. In general,
the taxpayer's investment in the contract should be the amount of premiums
paid less any dividends not included in income. IRC Section 72(e)(6). Discussion: Question 2
With respect to the payment at death issue, life insurance proceeds payable
by reason of death are excludible from gross income for income tax purposes.
IRC Section 101. I see no reason why existence of a policy loan affects
the excludibility issue. Discussion: Question 4
When an asset subject to indebtedness is donated to charity, the portion
of the asset subject to the debt is deemed sold in a taxable transaction
and the remainder is deemed donated to the charity. The gain or loss on
the sale portion is determined by taking the debt assumed by the charity
as sales proceeds against a portion of the basis computed by multiplying
the taxpayer's whole basis by a fraction the numerator of which is the debt
assumed and the denominator is the total value of the property. See Regulation
Sections 1.1011-2(a)(3) and 1.1011-2(b). The charitable deduction is the
difference between the gross value of the property and the underlying indebtedness. | 
