Atwood v. Commissioner

T.C. Memo. 1999-61

UNITED STATES TAX COURT

STEPHEN L. AND COLLEEN ATWOOD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 19748-97. Filed March 4, 1999.

Stephen L. and Colleen Atwood, pro sese.

James F. Prothro, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

THORNTON, Judge: Respondent determined a deficiency of

$10,756 in petitioners’ 1995 Federal income tax and an accuracy-

related penalty in the amount of $2,151 pursuant to section 6662.

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the year at issue, and all
 - 2 -

Rule references are to the Tax Court Rules of Practice and

Procedure.

The issues remaining for decision are: (1) Whether

petitioners are taxable on distributions totaling $38,117 from

the termination of a life insurance policy and an endowment

policy; (2) whether petitioners are entitled to deduct interest

on amounts borrowed against these two policies; and (3) whether

petitioners are liable for an accuracy-related penalty for a

substantial understatement of income tax.1

FINDINGS OF FACT

The parties have stipulated some of the facts, which are so

found. The stipulation of facts with attached exhibits is

incorporated herein by this reference. When they petitioned the

Court, petitioners were married and resided in Dallas, Texas.

In 1986, petitioner husband purchased a single premium life

insurance policy from First Colony Life Insurance Co. (First

Colony), paying a single premium of $25,000. On March 8, 1988,

petitioner wife purchased a single premium endowment policy from

National Western Life Insurance Co. (National Western), paying a

single premium of $50,000.

1
Petitioners stipulated that they failed to report taxable
interest income in the amount of $26 on their 1995 joint Federal
income tax return.
 - 3 -

Each of the policies permitted the owner to borrow generally

up to the amount of policy cash value, using the policy as

security. Each contract required payment of a specified rate of

interest on amounts borrowed, with any accrued but unpaid

interest to be added to the loan and to bear interest at the same

rate. Each contract provided for the termination or lapse of the

policy when the total loan, including unpaid interest, exceeded

the policy cash value (the value of the single premium

accumulated with interest less certain specified charges).

Because of financial hardship and in order to pay personal

living expenses, petitioners each borrowed the maximum allowable

amounts against their policies. They each failed to completely

repay these loans or interest thereon, resulting in the

termination of each policy in 1995.

When First Colony terminated petitioner husband’s policy,

his outstanding loan balance, exclusive of certain unpaid

interest, was $39,403.63. The policy had a cash value of

$39,843.11, and a cash surrender value of $439.48

($39,843.11 minus $39,403.63). Upon termination, First Colony

sent petitioner husband a check in the amount of the cash

surrender value ($439.48). First Colony also issued petitioner

husband a Form 1099-R, reflecting a taxable gain of $14,843.11,

which the company computed as the cash value of $39,843.11, less

his investment in the contract of $25,000.
 - 4 -

When National Western terminated petitioner wife’s policy,

her outstanding loan balance was $73,274.49. National Western

issued petitioner wife a Form 1099-R, reflecting a taxable gain

of $23,274.49, which the company computed as the outstanding loan

balance of $73,274.49, less her investment in the contract of

$50,000.

On their 1995 joint Federal income tax return, petitioners

reported no taxable distributions from their terminated insurance

policies. Respondent determined that petitioners had income of

$14,843 from the First Colony policy and $23,274 from the

National Western policy.

OPINION

In general, with exceptions not applicable here, any amount

which is received under a life insurance contract or endowment

contract before the annuity starting date and which is not

received as an annuity is included in gross income to the extent

it exceeds the investment in the contract. Sec. 72(e)(1)(A),

(5)(A), (C). The investment in the contract is defined generally

as the aggregate amount of premiums or other consideration paid

for the contract less aggregate amounts previously received under

the contract, to the extent they were excludable from gross

income. Sec. 72(e)(6).

The derivation and computation of the amounts reported on

the Forms 1099-R by First Colony and National Western upon
 - 5 -

termination of petitioners’ policies are not in dispute. The

only issue is whether these amounts are includable in

petitioners’ gross income as amounts received within the meaning

of section 72(e).

Noting that very little cash was paid directly to them upon

cancellation of the policies, petitioners argue that the amounts

at issue represent merely “paper transactions” on the books of

the insurance companies. They argue that, in borrowing against

the policies, they were borrowing their own money, and that

capitalized interest on the loans merely increased their

investments in the contracts. We disagree.

Petitioners’ insurance contracts, by their terms, treated

the policy loans, including capitalized interest, as bona fide

indebtedness. For Federal income tax purposes, their policy

loans constituted true loans, rather than cash advances, and were

not taxable distributions when received. See Minnis v.

Commissioner, 71 T.C. 1049, 1057 (1979).2 The capitalized

interest on these loans is properly treated as part of the

principal of this indebtedness. See Allan v. Commissioner, 86

2
Subsequent to the decision in Minnis v. Commissioner, 71
T.C. 1049 (1979), which dealt specifically with loans under an
annuity contract, Congress enacted sec. 72(e)(4), which generally
treats loans under annuity contracts as taxable distributions.
Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248,
sec. 265(a), 96 Stat. 544. Loans under life insurance contracts
and endowment contracts (other than modified endowment contracts)
are excepted from this treatment. See sec. 72(e)(5)(A)(i).
 - 6 -

T.C. 655, 661-667 (1986)(advances for interest that were added to

the nonrecourse mortgage principal, pursuant to the terms of the

mortgage, constituted a true debt obligation), affd. 856 F.2d

1169 (8th Cir. 1988).

When petitioners’ policies terminated, their policy loans,

including capitalized interest, were charged against the

available proceeds at that time. This satisfaction of the loans

had the effect of a pro tanto payment of the policy proceeds to

petitioners and constituted income to them at that time. See

Minnis v. Commissioner, supra at 1056 (dictum); Caton v.

Commissioner, T.C. Memo. 1995-80; Dean v. Commissioner, T.C.

Memo. 1993-226. A contrary result would permit policy proceeds,

including previously untaxed investment returns, to escape tax

altogether and finds no basis in the law.

Petitioners argue that if the distributions on the

terminated insurance policies are taxable, then they should be

allowed an offsetting deduction for interest paid on the policy

loans. Deductions are a matter of legislative grace, and

petitioners bear the burden of showing that they are entitled to

the claimed deductions. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992). Section 163(a) generally

allows as an interest deduction all interest paid or accrued

within the taxable year on indebtedness. As an exception to this

general rule, however, in the case of a taxpayer other than a
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corporation, section 163(h) generally disallows any deduction for

“personal interest”, defined to include any interest expense that

does not fall within one of the five categories listed in section

163(h)(2). These categories may be described generally as (1)

trade or business interest; (2) investment interest; (3) interest

used to compute passive income or loss; (4) qualified residence

interest; and (5) interest payable on certain deferred estate tax

payments. Petitioners have presented no evidence to show that

the interest expenses in question fall within any of these five

enumerated categories. To the contrary, petitioner husband

testified at trial that he borrowed against his life insurance

policy “for no other reason than to live in the absence of a

job.” On brief, petitioners reiterate that this was their reason

for borrowing against their policies. We conclude, therefore,

that the interest expense in question was nondeductible personal

interest.

Relying on an exception in section 264(c)(3), petitioners

argue that their interest expenses are not subject to

disallowance under section 264(a)(2), which generally disallows

interest deductions on indebtedness incurred or continued to

purchase or carry a single premium life insurance, endowment, or

annuity contract.3 It appears that neither the general rule of

3
SEC. 264. CERTAIN AMOUNTS PAID IN CONNECTION WITH
INSURANCE CONTRACTS.
(continued...)
 - 8 -

section 264(a)(2) nor the cited exception applies to the case at

hand.4 Because we have concluded that the interest in question

3
(...continued)
(a) General Rule.--No deduction shall be allowed for--

* * * * * * *

(2) Any amount paid or accrued on indebtedness incurred
or continued to purchase or carry a single premium life
insurance, endowment, or annuity contract.

(3) Except as provided in subsection (c), any amount
paid or accrued on indebtedness incurred or continued
to purchase or carry a life insurance, endowment, or
annuity contract (other than a single premium contract
or a contract treated as a single premium contract)
pursuant to a plan of purchase which contemplates the
systematic direct or indirect borrowing of part or all
of the increases in the cash value of such contract
(either from the insurer or otherwise).

* * * * * * *

(c) Exceptions.--Subsection (a)(3) shall not apply to any
amount paid or accrued by a person during a taxable year on
indebtedness incurred or continued as part of a plan referred to
in subsection (a)(3)--

* * * * * * *

(3) if such amount was paid or accrued on indebtedness
incurred because of an unforeseen substantial loss of income
or unforeseen substantial increase in his financial
obligations * * *.
4
There is no evidence in the record that the loans in
question were “incurred or continued to purchase or carry” single
premium life insurance or endowment contracts, within the meaning
of sec. 264(a)(2). Moreover, the exception contained in sec.
264(c)(3) pertains only to plans referred to in sec. 264(a)(3),
which specifically excludes single premium contracts.
 - 9 -

was nondeductible personal interest under section 163(h),

however, the issue is moot.

We hold, therefore, that petitioners are taxable on

distributions from their terminated policies in the amount of

$38,117 and are not entitled to deductions for interest paid on

their policy loans.

Substantial Understatement of Income Tax

Respondent also determined an accuracy-related penalty under

section 6662 for a substantial understatement of tax for taxable

year 1995. Section 6662(a) imposes a 20-percent penalty on the

portion of an underpayment of tax attributable to, among other

things, a substantial understatement of income tax, which is

defined as an understatement that exceeds the greater of 10

percent of the tax required to be shown or $5,000. Sec.

6662(d)(1)(A). Petitioners reported total tax of $6,231 and

understated their tax in the amount of $10,756. Therefore, there

was a substantial understatement of tax.

Any understatement is reduced to the extent that it is

attributable to an item that was adequately disclosed and has a

reasonable basis, or for which there was substantial authority

for its tax treatment. Sec. 6662(d)(2)(B). Notwithstanding that

petitioners were issued Forms 1099-R indicating taxable

distributions upon termination of their insurance policies,

petitioners made no disclosure on their return of the relevant
 - 10 -

facts affecting their exclusion of these amounts from gross

income. See sec. 6662(d)(2)(B)(ii)(I). Petitioners have

established no substantial authority for excluding these amounts

from income.

Accordingly, we sustain respondent’s imposition of the

accuracy-related penalty.

To reflect the foregoing,

Decision will be entered for

respondent.