Life Insurance – It’s for the Living
If you’re reading this post, you survived the Thanksgiving holiday – hopefully, without much family drama.[i] Then again, there may have been moments, inspired by an overload of obligatory togetherness, that caused you to think about life insurance, either on your own life or on that of another.[ii]
Coincidentally, a recent decision of the U.S. Tax Court considered the situation of a Taxpayer who, about thirty years before the taxable year at issue, purchased two whole life insurance policies, one on the life of each of their two young children.[iii]
Query: was Taxpayer planning ahead for some future Thanksgiving “holiday” on which one of the pampered ingrates will finally cross the line from being just disagreeable to being downright hateful? Not quite.
Child Life Insurance
Why would a parent take out a whole life insurance policy on their minor child? For one thing, it is likely easier to acquire a policy on behalf of a child while the child is young and, hopefully, healthy. Because of the permanent nature of the policy[iv] – we’ll turn to this shortly – the early acquisition of a policy should ensure continued coverage for the child as they age, even with changes in the child’s health. Moreover, the policy should accumulate cash value over time, which may someday be accessed by the child as an adult. Finally, given the child’s age, the premiums payable to maintain the policy – initially by the parent and later by the child – should be lower and more affordable.[v]
As we’ll see shortly, Taxpayer may not have been thinking along these lines when they acquired the policies on the lives of their children. Before describing Taxpayer’s circumstances and reviewing the question before the Tax Court, however, it may be helpful to provide an overview of whole life insurance and some of the related tax considerations.
Whole Life: An Oversimplified Summary
A whole life policy is a type of “permanent” life insurance, which means the insured individual[vi] is covered for the duration of their life as long as premiums are paid on time.[vii] Premiums on such policies may be fixed for the life of the policy. As long as the policy owner keeps making premium payments, the policy will stay in effect.
Like other forms of permanent life insurance, whole life policies include an investment feature (the “cash value”) that is managed by the issuer of the policy. A portion of each premium payment covers the cost of the policy’s death benefit while the balance contributes to the policy’s cash value. The cash value may be guaranteed to grow at a set rate each year until it is equal to the face amount of the policy; of course, the policy’s performance may surpass this rate. Importantly, neither the income earned on the cash value of the policy, nor the appreciation in the policy’s cash value, is subject to income tax while it remains within the policy’s cash value account.[viii]
In any case, when the insured dies, the insurance company will pay the death benefit (subject to certain adjustments, below) to the beneficiaries of the policy. No matter how much cash value accumulated in the policy before the death of the insured, the beneficiaries can generally collect no more than the stated death benefit. The death benefit that is paid to the beneficiary of the policy – not necessarily the same person as the owner of the policy[ix] – should not be subject to income tax.[x]
Parties Interested in the Policy
At this point, the distinction should be made between the owner of a permanent policy and the policy’s beneficiary.
The owner is the person that controls the policy during the life of the insured.[xi] While the owner is generally responsible for paying the premiums on the policy, the owner has the right, for example, to change the beneficiaries of the policy, and also the right to surrender, sell, pledge, or otherwise dispose of the policy.[xii] Significantly for purposes of this post, the owner may have the right to borrow against the cash value of the policy.
Policy Loans
The cash value of the policy serves as collateral for any amount the owner may borrow against the policy. Any loans the policy owner has not repaid (plus interest) by the time the insured dies will be subtracted from the death benefit that is otherwise payable to the beneficiaries of the policy upon the death of the insured.[xiii]
Before the policy owner can borrow against the policy, the policy’s cash value has to reach a certain threshold – after all, the cash value will serve as the collateral for the loan. Thus, it can take time for such value to grow sufficiently, depending, for example, upon the policy’s investment performance and the amount of the loan. Once that threshold is reached, the policy owner can borrow money against the policy’s cash value.[xiv]
Of course, a borrower’s receipt of loan proceeds is not taxable to the borrower because the loan must be repaid (with interest);[xv] the borrower has not realized any accretion in value. The same principle applies with respect to an owner’s policy loan.
Surrendering the Policy
Alternatively, the policy owner may surrender the policy in exchange for its cash value.[xvi]
Where the owner surrenders the policy to the issuer in exchange for an amount of money equal to the cash surrender value of the policy, the owner must include in gross income the excess of such amount over the owner’s investment in the insurance contract (i.e., the aggregate amount of premiums or other consideration paid for the contract,[xvii] less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income).[xviii]
The income recognized by the owner on the surrender of the policy is treated as ordinary income.[xix]
With the foregoing basics under our belts, let’s consider Taxpayer’s situation.
Taxpayer’s Policies
Taxpayer had two children.[xx] As mentioned above, Taxpayer applied for and purchased two whole life insurance policies, one on the life of each child. Taxpayer was the owner and paid the annual premiums on the policies. He was also the beneficiary of each policy.
Under the terms of the policies, Taxpayer was allowed to borrow against the cash surrender value of each policy, up to a maximum amount equal to such cash surrender value. Interest was chargeable on any such loan at a variable rate (not greater than 8 percent) and was payable on the policies’ annual anniversary date. Any unpaid interest was added to the loan balance and subject to interest at the rate payable on the loan.
Either policy could be surrendered by Taxpayer to the issuer of the policy for its cash surrender value at any time before the insured child’s[xxi] death.
The cash surrender values of the policies increased over time as premiums were paid and as accumulated dividends[xxii] built up within the policies.
The Loans
After paying premiums on the two policies for about 18 years, Taxpayer borrowed an amount from each policy.
For the next ten years, Taxpayer did not pay annual premiums on either of the policies out of his own pocket. Instead, Taxpayer borrowed additional amounts from each policy to cover the annual premiums. The interest accrued on the amounts borrowed to pay the premiums was added to the outstanding loan balance on each policy.
The cash surrender values of the policies were reduced by the amounts of outstanding policy debt.
Surrender
During the year at issue, Taxpayer notified the issuer of his intent to terminate both policies and satisfy the outstanding loans.
The issuer acknowledged Taxpayer’s decision and requested that Taxpayer submit surrender forms to finalize the terminations. The issuer further advised Taxpayer that surrendering the policies could result in taxable income.
Shortly thereafter, Taxpayer sent the Issuer the necessary surrender forms for both policies, which the issuer then processed to terminate the policies. The issuer also issued two checks to Taxpayer representing the cash surrender value of each policy.
Tax Reporting
The issuer subsequently sent Taxpayer an IRS Form 1099–R for each policy on which was shown (i) the gross distribution from each policy, consisting of the outstanding policy loan balance and an amount of cash, and (ii) the taxable amount for each policy, which was equal to the amount of the gross distribution with respect to a policy reduced by the total premiums paid (or deemed paid) for such policy.
Taxpayer did not include this taxable income on his individual federal income tax return for the year at issue.
The IRS increased Taxpayer’s income for the year the polices were surrendered by the taxable amounts shown in the Forms 1099–R.
Taxpayer petitioned the Tax Court to review the adjustments made by the IRS.
The Tax Court
The principal issue for decision before the Court was whether the above-described distributions with respect to the two policies were includible in Taxpayer’s income for the year of surrender.
Basics
The Court began by explaining that gross income includes income “from whatever source derived,” including “[i]ncome from life insurance . . . contracts.”[xxiii] The Court stated further that gross income includes any amount received under a life insurance contract to the extent those amounts exceed the investment in the contract.[xxiv]
The Court then explained that a loan against a life insurance policy’s cash value is a loan from the issuer insurance company to the owner of the policy. Because policy loans are treated as loans, they are not taxable distributions to the owner-borrower when the funds are received.
According to the Court, a taxpayer constructively receives proceeds from a terminated life insurance policy when, and to the extent that, existing policy loans are satisfied with the policy’s available cash surrender value.
Taxpayer’s Loans
The Court observed that Taxpayer took out loans against the two policies and received the loan amounts. When Taxpayer terminated the policies, these loans were completely satisfied.
The Court found that Taxpayer constructively received proceeds in the amount of the outstanding policy loan balances in addition to receiving a check for the remaining balance of each policy’s cash surrender value.
Based on the foregoing, the Court concluded that the sum of (i) the proceeds Taxpayer actually received (the checks), plus (ii) the proceeds that Taxpayer constructively received (from the satisfaction of the outstanding balances of the policy loans), represented taxable income to Taxpayer for the year at issue to the extent that the proceeds exceeded the premiums paid.[xxv]
Obvious Outcome?
Yes. Then again, this was a nonprecedential summary opinion in a small tax case (or “S case”),[xxvi] which means it involved relatively simple, straightforward facts, and a relatively small deficiency.
Still, its facts highlighted – though it was not at issue – an important consideration in the acquisition and use of permanent life insurance and its investment element.
As stated earlier, there are bona fide reasons for the purchase of some form of permanent life insurance on the life of a family member who is much younger than the owner-beneficiary of the policy.
In the absence of any such reasons, as manifested by the post- acquisition history of such a policy, query whether the policy should be treated as a life insurance contract for purposes of the Code.
The primary purpose of a life insurance policy is to provide death benefits to the beneficiaries of the policy; in this case, to Taxpayer, the insured’s parent.[xxvii]
What about a policy that, based upon its actual history, is oriented primarily toward investment,[xxviii] even if it satisfies the “numerical tests” applied by the Code[xxix] in making this determination?
For better or worse, I’m inclined to tread warily when someone suggests using life insurance other than for its originally intended purpose.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
Sign up to receive my blog at www.TaxSlaw.com.
[i] Of course, the rest of the holiday season remains.
[ii] Let’s assume you have an insurable interest in this other individual’s life.
Under N.Y. Insurance Law Sec. 3205(a)(1), the term “insurable interest” means: (A) in the case of persons closely related by blood or by law, “a substantial interest engendered by love and affection”; (B) in the case of other persons, “a lawful and substantial economic interest in the continued life, health or bodily safety of the person insured, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the insured.”
[iii] Fugler v. Comm’r, T.C. Summary Opinion 2025-10.
[iv] Whole life is just one type of permanent life insurance policy, and it may be the simplest. Others include universal life and variable life, which are more complex but afford greater flexibility.
[v] Before acquiring a policy, there is no substitute for consulting a knowledgeable, experienced, and reputable life insurance broker and adviser. If you don’t know such an individual, ask around. Don’t just accept the one person recommended by your attorney or other adviser – this individual may turn out to be the perfect choice, but you owe it to yourself to do some diligence.
[vi] I.e., the person whose death will contractually obligate the issuer of the policy to pay the policy’s stated death benefit to those persons who are identified by the insurance contract as the beneficiaries of the policy.
[vii] Permanent life insurance is designed to last the insured’s life (though some permanent policies may “mature” when the insured reaches a certain “advanced” age – often 121). Thus, a permanent policy is different than term life insurance, which covers the insured individual for a set period of time; for example, until a specific age, or for a specified number of years (often 10, 20, or 30 years).
The longer period over which the issuer of a permanent policy may be obligated to pay a death benefit is reflected in the amount of premium payable. As we’ll see, the investment element (or cash value) of a permanent policy is also reflected in the premium.
[viii] Provided the requirements of IRC Sec. 7702 are satisfied. This provision was added to the Code by the Deficit Reduction Act of 1984 (P.L. 98-369) to ensure that a policy qualifies as a “life insurance contract” and is not treated primarily as an investment vehicle. See JCS-41-84, p. 645.
[ix] This fact facilitates estate planning to ensure the policy is not included in the gross estate of the insured.
[x] Provided the policy is treated as a life insurance contract for tax purposes. IRC Sec. 101 and Sec. 7702.
Sec. 101 reads as follows: “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.”
There are some limitations. See, for example, the “transfer for value” rule under IRC Sec. 101(a)(2) and the “reportable policy sale” rule under IRC Sec. 101(a)(3).
[xi] The owner holds the so-called “incidents of ownership” with respect to a policy. In the case of a typical life insurance trust established to acquire and hold insurance on the life of the settlor of the trust, the trustee controls the policy.
[xii] The owner may “voluntarily” assign responsibility for the premium payments or restrict the exercise of their rights in the policy by contract with another party. For example, a shareholders’ agreement may require the corporation to pay the premiums on policies owned by the insured shareholders (constructive distributions by the corporation), or a split-dollar agreement may require the owner-employee to pledge the policy as collateral to ensure the premiums (plus interest) are repaid to the employer on the death of the employee.
[xiii] It is possible for the beneficiaries to end up with less than the face amount of the policy.
[xiv] The owner may also use the cash value to pay premiums.
The amount of the policy loan may be capped at a percentage of the cash value. The cash value itself may continue to grow.
[xv] It’s important to note that, typically, there is no due date for repayment of the loan – the amount of the death benefit payable on the insured’s demise will be reduced by the unpaid balance of the policy loan.
That said, in order to preserve loan treatment, interest should be paid regularly, even if such payment is charged against the policy’s cash value.
If the amount taken from the cash value of a policy is not a loan but a withdrawal, the amount by which the withdrawal exceeds the policy’s cost basis will be included in the owner’s gross income for tax purposes. Stated differently, withdrawals up to the cost basis are not taxable.
[xvi] When the owner of a policy surrenders the policy to the issuer, the policy is canceled.
[xvii] Under § 1016(a)(1)(B), following the TCJA, the cost basis of a life insurance contract is not reduced by the cost of insurance.
[xviii] Rev. Rul. 2009-13, Sit. 1.
IRC Sec. 72(e)(5)(A) requires that the amount be included in gross income but only to the extent it exceeds investment in the contract. For this purpose, IRC Sec. 72(e)(6) defines “investment in the contract” as of any date as the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income.
[xix] Rev. Rul. 2009-13, Sit. 1; Rev. Rul. 64-51.
[xx] We are not given their ages. The only point of reference is the number of years (approximately 25) Taxpayer had been practicing law at the time of purchasing the policies.
[xxi] Taxpayer’s children.
[xxii] The issuer was a mutual life insurance company.
[xxiii] IRC Sec. 61(a)(9); IRC Sec. 72(a)(1).
[xxiv] IRC Sec. 72(e)(1)(A), Sec.72(e)(3).
[xxv] IRC Sec. 61(a)(9), (a)(11). The Court stated that Taxpayer offered “unclear reasons” why this analysis was in error.
[xxvi] Designated by the “S” that appears at the end of the docket number: Docket No. 27150-21S.
[xxvii] The opinion is silent as to whether the children were important to Taxpayer’s business, or that Taxpayer was in some way dependent upon them, either at the time of purchase or at any subsequent time.
[xxviii] Taxpayer claimed that the loans were used in its mining and logging business and, so, the interest should have been deductible by Taxpayer as a business expense. The Court responded that Taxpayer failed to present any evidence that he was involved in any such business or, if so, that the loan proceeds were used in such trade or business. Thus, the Court concluded the loans were personal.
[xxix] IRC Sec. 7702. The policy was issued by one of the highest rated life insurance companies. It appears that no question was raised regarding the true nature of the policy.