T.C. Memo. 2009-285
UNITED STATES TAX COURT
BILL S. MCGOWEN AND CAROLYN M. MCGOWEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14116-07. Filed December 14, 2009.
Harold A. Chamberlain, for petitioners.
Thomas Fenner, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: Respondent determined an income tax
deficiency of $171,631 for petitioners’ 2004 tax year.
Respondent conceded the section 6662 penalty. The two remaining
issues are: (1) Whether petitioners’ income as a result of the
termination of a variable life insurance policy should be
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characterized as income from a life insurance contract pursuant
to section 72(e) or income from the discharge of indebtedness;
and (2) whether petitioners’ income, if derived from the
discharge of indebtedness, should be excluded from their gross
income pursuant to section 108(g).
All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
FINDINGS OF FACT
Some of the facts were stipulated. The stipulation of
facts, together with the exhibits attached thereto, is
incorporated herein by this reference.
Bill S. McGowen (Mr. McGowen) and Carolyn M. McGowen (Mrs.
McGowen) are husband and wife, and they filed a joint Federal
income tax return for the year 2004. At the time the petition
was filed, they resided in New Mexico.
On May 30, 1986, Mrs. McGowen purchased a single-premium
variable life insurance policy (insurance policy) on her own life
for $500,000. Upon her death, the insurance policy would have
conferred on the beneficiary a benefit in excess of the policy
debts she incurred. The death benefits consist of the return on
the investments made by the insurer and the guaranteed amount.
According to the insurance policy, the insurer invests in mutual
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funds1 exclusively. The insurer purchases, sells, and holds the
shares of the mutual funds, but does not manage them. The
insurer purchases shares in the mutual funds from separate
investment advisers if that mutual fund satisfies the insurance
policy’s restrictions and objectives and sells them if the mutual
fund ever fails to meet those standards. In contrast, the
guaranteed amount is determined on the basis of the year the
beneficiary receives the benefit. In the initial year, the
beneficiary will receive solely the guaranteed amount. For all
subsequent years the benefit will vary in accordance with the
positive return of the investment in the mutual fund but will not
be less than the guaranteed amount.
Mrs. McGowen had the right to cancel the insurance policy
and receive its net cash value.2 The insurance policy defines
the net cash value as the cash value3 minus any policy debt. The
policy debt consists of the sum of all outstanding loans plus
accrued interest. The insurance policy permits Mrs. McGowen to
1
A mutual fund is an investment company that pools money
from the sale of its corporate shares and invests the money in
stock, short-term money market instruments, and other securities.
2
The net cash value at the time of cancellation is also
referred to as the net cash surrender value.
3
The insurance policy defines cash value using a calculation
where “the cash value on a date equals the tabular cash value on
the date plus the net single premium on that date for the
Variable Insurance amount.” Tabular cash value refers to the
value shown on the insurance policy’s schedule B.
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borrow money at a 5.25-percent annual interest rate. Any unpaid
interest due at the end of the policy year will be added to the
amount of the loan. The insurance policy further requires that
the insurance policy itself serve as collateral and that the
insurance policy terminate if the policy debt ever exceeds the
cash value.
The insurance policy states that any amount borrowed by the
insured would cause a withdrawal of that exact amount from the
investment base and an allocation of that fund to a separate
general account. Any fund directed to the separate general
account would earn a 4.5-percent annual rate of return.
On May 31, 1989, Mrs. McGowen first exercised her right to
borrow $25,000 from the insurance policy to pay her personal
expenses. On the same day, she received a letter from the
insurer indicating that her investment base, net cash surrender
value, and death benefits would be decreased by $25,000. In a
letter dated June 29, 1989, the insurer sent another monthly
notice reporting Mrs. McGowen’s total loan balance of $50,104.28
based upon an additional $25,000 borrowed by Mrs. McGowen and the
accrued interest of $104.28. Mrs. McGowen would continue to
receive these monthly notices throughout the life of the
insurance policy. Over the next year, Mrs. McGowen borrowed
monthly amounts ranging from $5,000 to $25,000, totaling $235,000
by April 1990. On June 1, 1990, Mrs. McGowen made a $7,444.22
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payment, which was applied towards the interest accrued on the
loans. From June 11, 1990, to April 8, 1991, Mrs. McGowen
borrowed additional amounts totaling $216,000. In January 1992
she borrowed her last amount of $2,500. In addition, the insurer
also sent yearly reports stating that the amounts Mrs. McGowen
borrowed had accrued annual interest of $39,553.15 for the year
1998, $41,629.69 for the year 1999, $43,815.25 for the year 2000,
$46,115.55 for the year 2001, $48,536.62 for the year 2002, and
$51,084.79 for the year 2003. Those annual interest notices
stated in bold that the interest due would be added to her
outstanding loans if she did not make any payments. Last, Mrs.
McGowen received letters each year stating that if she
surrendered her insurance policy by a date certain she would
incur a taxable gain. Those letters indicated that on May 28,
1999, May 30, 2000, May 29, 2001, May 28, 2002, and May 28, 2003,
she would have incurred a taxable gain of $413,124.30,
$456,684.62, $480,124.92, $506,400.60, and $536,831.59,
respectively. Additionally, the record demonstrated that the
insurer corresponded with Mr. McGowen, apprising him of the
financial history of Mrs. McGowen’s insurance policy.
By 1992 Mrs. McGowen had borrowed amounts totaling $536,500.
Before the cancellation of the insurance policy, Mrs. McGowen
had made only the one payment of $7,444.22 on June 1, 1990. In
September 1993 Mrs. McGowen did make an inquiry regarding the
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surrender of her policy but apparently chose not to act. By 2000
the interest accrued on the policy debt had drastically exceeded
the diminishing return rendered by both the investment base and
the general account. Consequently, the already reduced net cash
surrender value of the insurance policy continued to shrink
rapidly. The insurance policy had net cash surrender values of
$78,293.21 on May 28, 2000, $55,617.96 on May 28, 2001,
$33,357.02 on May 28, 2002, and $12,703.22 on May 28, 2003. By
November 28, 2003, the monthly statement had indicated that the
net cash surrender value had been diminished to $2,782.25.
On March 1, 2004, the insurer issued a notice warning Mrs.
McGowen that her outstanding policy debt had exceeded the
insurance policy’s cash value as of February 28, 2004, and the
termination of the insurance policy would occur within 31 days if
she did not make a payment of $108,313.42. That notice also
stated that the cancellation of the insurance policy would be a
taxable event, whereby she would have to recognize $562,746.04 as
of February 28, 2004. Interest would still accrue during the 31-
day grace period. Mrs. McGowen did not make the payment. On
March 30, 2004, the insurer sent a letter informing Mrs. McGowen
of the cancellation of the insurance policy and the issuance of
an Internal Revenue Service Form 1099-R, Distributions From
Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,
Insurance, Contracts, etc., reporting a gain of $565,224.11.
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OPINION
Burden of Proof
Respondent’s determinations in the notice of deficiency are
presumed correct, and petitioners bear the burden of disproving
those determinations. See Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115 (1933).
Issue 1. Gross Income
Gross income includes all income from whatever source
derived. Sec. 61. Section 61 lists specifically some forms of
gross income, including the income from a life insurance contract
and the income from a discharge of indebtedness. See sec.
61(a)(10), (12). Neither party disputes that petitioners have
received income as a result of the termination of their variable
life insurance policy and that petitioners intended to report
that income on their 2004 joint return. The parties’ dispute
concerns the kind of income petitioners received. A variable
life insurance contract is a permanent form of insurance in which
the cash value is based on the performance of an underlying pool
of securities. See Much v. Pac. Mut. Life Ins. Co., 266 F.3d
637, 638 (7th Cir. 2001). The Court holds that petitioners
received income attributable to the termination of their variable
life insurance policy pursuant to section 72(e).
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Petitioners argue that their income arose from the discharge
of Mrs. McGowen’s indebtedness of $1,065,224.11. The Court
respectfully disagrees.
For Federal income tax purposes, petitioners’ policy loans
were true loans. See Atwood v. Commissioner, T.C. Memo. 1999-61.
The parties have agreed to this fact, and the Court concurs. The
insurance policy required by its terms the payment of a 5.25-
percent interest rate on amounts borrowed against the policy, a
requirement indicative of a bona fide debt. See Salley v.
Commissioner, 55 T.C. 896, 903 (1971), affd. 464 F.2d 479 (5th
Cir. 1972); Kay v. Commissioner, 44 T.C. 660, 670-672 (1965);
Dean v. Commissioner, 35 T.C. 1083, 1085 (1961). Consequently,
petitioners would not have had to recognize these loans as
taxable income when they received them. See Commissioner v.
Indianapolis Power & Light Co., 493 U.S. 203, 207-208 (1990);
Commissioner v. Tufts, 461 U.S. 300, 307 (1983).
Petitioners did not receive income from discharge of
indebtedness. A discharge of indebtedness occurs when “the
debtor is no longer legally required to satisfy his debt either
in part or in full.” Caton v. Commissioner, T.C. Memo. 1995-80;
see also United States v. Centennial Savings Bank FSB, 499 U.S.
573, 580-581 (1991). On the basis of facts presented, the Court
cannot characterize the source of petitioners’ income as income
derived from the discharge of indebtedness. The record here
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indicates that the loans to Mrs. McGowen were not discharged:
they were extinguished after the insurer had applied the cash
value of the insurance policy towards the debt owed by Mrs.
McGowen. The insurance policy itself was the sole collateral for
which the insurer can seek repayment of the amount Mrs. McGowen
borrowed. Consequently, the insurance policy mandates the
immediate surrender of the insurance policy once the amount
borrowed against the policy exceeds the cash surrender value.
Petitioners had been fairly warned by the numerous letters
notifying them of the increasing possibility of the cancellation
of Mrs. McGowen’s insurance policy.
The present record instead supports the characterization of
petitioners’ income as income received from a life insurance
contract. Any distribution from Mrs. McGowen’s insurance policy
would fall within the purview of section 72(e)(1). Section
72(e)(1) mandates that a taxpayer include in his gross income any
amount that is received under an annuity, endowment, or life
insurance contract and is not received as an annuity. Section
72(e)(5) limits this inclusion to the amount exceeding the
investment in the contract. Investment in the contract as of any
date will be the difference between the aggregate of premiums or
other consideration paid for the contract before such date, and
the aggregate amount received under the contract before such date
to the extent that such amount was excluded from gross income.
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Sec. 72(e)(6). The Court cannot conclude that Mrs. McGowen
received any direct distributions from her life insurance policy.
Nevertheless, for the following reasons, the Court holds that
petitioners must recognize the indirect distribution of income
Mrs. McGowen received from her insurance policy under section
72(e).
A taxpayer may be required to recognize an indirect
distribution of an insurance policy’s cash value as gross income
under section 72. This Court reached that conclusion in Atwood
v. Commissioner, supra, among other cases. Each of the married
taxpayers in Atwood purchased an individual life insurance
policy, paying a single premium. See id. Those taxpayers each
borrowed the maximum amount permitted by their insurance policies
yet did not make any loan payments, causing those policies to be
terminated. Upon the termination of the husband’s policy, the
insurer issued to the husband a check in the amount by which the
cash surrender value of his policy exceeded his loan. The wife
did not receive a check upon termination of her policy because
her loan had exceeded the cash surrender value of her policy.
Both taxpayers received a Form 1099 reflecting gain from the
surrender of their insurance policy. This Court held in Atwood
that the taxpayers received gross income under section 72(e).
This Court reasoned that the taxpayers had received a deemed
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distribution to the extent of their satisfied loans and explained
further:
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. * * *
Id. Any conclusion otherwise “would permit policy proceeds,
including previously untaxed investment returns, to escape tax
altogether and finds no basis in the law.” Id.
Similar to the taxpayers in Atwood, petitioners must
recognize the indirect distribution from Mrs. McGowen’s insurance
policy as gross income under section 72(e). The insurer applied
the cash value of Mrs. McGowen’s insurance policy to extinguish
her loan. This would then have the same effect as the “pro tanto
payment” described by this Court in Atwood. Furthermore, this
Court maintains that the distributed policy proceeds attributed
to the return on investments must be taxed since the accruals on
the investments were not previously taxed. Untaxed accrual on an
investment is often referred to as inside buildup.
Pursuant to section 72(e), petitioners must recognize
$565,224.11 as gross income, based upon the difference between
Mrs. McGowen’s investment in the contract and the cash value of
the policy on the date of cancellation. The cash value at the
time of surrender was $1,065,224.11, which, by the contractual
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terms, cannot be less than the aggregate of all the amounts
borrowed by Mrs. McGowen and the accrued interest. Mrs.
McGowen’s investment in the contract was $500,000. Also, the
excess of the insurance policy’s cash surrender over the cost of
the contract would be attributable to the previously untaxed
inside buildup which Mrs. McGowen must now recognized as income
of $565,224.11.
Issue 2. Exclusion From Gross Income
Petitioners have raised the issue of whether the income, if
derived from the discharge of indebtedness, should be excluded
from their gross income under section 108(g). This issue is moot
because the Court has held that Mrs. McGowen’s debts were not
discharged and, thus, petitioners’ income was not from discharge
of indebtedness.
Decision will be entered
for respondent.