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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers. Here’s the question of the day.
Question: I have a client whose life insurance policy terminated because his debt on the policy exceeded its cash value. Is the entire loan balance—including accumulated interest on the principal—treated as a distribution?
Answer: Yes. Consider the recently released Tax Court opinion, Black v. Commissioner, T.C. Memo. 2014-27 (2/14/14).
In Black, the taxpayer borrowed about $100,000 from his life insurance policy, which incurred an additional $90,000 in interest. The taxpayer failed to repay the loan, and the policy was terminated, satisfying and extinguishing the full debt.
The taxpayer had invested about $80,000 in the policy and contended that he was only required to include $20,000 in gross income from the deemed distribution (i.e. the loan principal, $100,000, less his investment in the contract, $80,000).
The Tax Court disagreed, holding that the entire debt—including the capitalized interest—should be treated as a distribution when the policy terminated. Therefore, the taxpayer should recognize $110,000 of gross income (i.e. the loan principal plus the capitalized interest, $190,000 total, less his investment in the contract, $80,000).
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