In a recent income tax case, the Tax Court affirmed the principal that the proceeds received from surrender of an insurance policy in excess of the policyholder's investment in the policy are taxable as income. This is the case even if almost all of the proceeds were used to repay a loan against the policy.
The taxpayers in Brach v. Commissioner were the owners of an insurance policy that allowed the policyholder to borrow up to the entire cash value of the policy. When the taxpayers became unable to pay the premiums or make loan repayments, they had to cancel the policy. The termination resulted in a gross distribution of about $65,903, which, after repayment of the loan, was reduced to $3,786. Taxable income on the distribution, however, was over $33,125 (the difference between the cash value and the taxpayers' investment of $32,778 in the policy). The taxpayers' failure to report the income resulted in a deficiency of $6,949 and an accuracy-related penalty of $1,390.
The Court rejected the position taken by the taxpayers that the surrender of the policy gave rise to "cancellation of indebtedness income" which, in light of the fact that the taxpayers were insolvent, was not includible in gross income by virtue of Section 108(a)(1)(B)(7) of the Internal Revenue Code.
Instead, the Court cited Section 72, which provides that an amount received in connection with a life insurance contract which is not received as an annuity generally constitutes gross income to the extent that the amount received exceeds the investment in the insurance contract. In this case, surrendering the policy entailed repayment of the loan. In contrast to repayment, "discharge of indebtedness" occurs when "the debtor is no longer legally required to satisfy his debt either in part or in full." Therefore, the taxpayers' debt obligation was satisfied rather than discharged.
Despite the clear rejection of the taxpayers' reporting, the Court found that imposition of a 20% penalty for underpayment was not appropriate. The taxpayers were relatively inexperienced in tax matters. They sought advice from a qualified professional, provided their adviser with all relevant information, and reasonably believed the adviser was competent to prepare their return. They had no reason to question the professional advice they received. Therefore, the underpayment fell within the exception under Section 6664(c)(1) which provides that an underpayment is not subject to penalty if the taxpayer establishes that there was reasonable cause for the underpayment and the taxpayer acted in good faith.
This case is illustrative of the Tax Court's willingness to consider all the facts, including a taxpayer's level of sophistication when deciding whether there was good faith reliance on expert advice. It is not clear that the Court would have held the same way had the taxpayers been better versed in tax matters or had they failed to disclose important information to their tax adviser.