A recent US Tax Court Memo identifies the financial risk in unwittingly or intentionally mismanaging a life insurance policy. In 1987, a policy owner purchased a single premium variable life policy (since this was pre Code Section 7702A, it was not considered a modified endowment contract) with a payment of $87,500. The policy contract permitted the owner to take loans from the policy, allowing any unpaid loans and interest that accrued to be added to the “policy debt.” Once the policy debt exceeded the cash value of the policy, the carrier could terminate the policy after giving the policy owner notice and the opportunity to pay down the policy debt to avoid termination.
For 10 years the policy owner took loans totaling $133,800 and allowed the debt to grow over the ensuing years, even after receiving updates on policy values spelling out the growing interest and policy debt. In October of 2011, the carrier notified the policy owner by letter that he would have to make a minimum payment of $26,061 to avoid termination, which would cause a taxable gain. The owner did not make the payment, and the carrier terminated the policy and issued a 1009-R to the policy owner.
The policy owner did not report the income on his joint tax return, though he and his wife did consult with tax advisors, including one that told them they were “going to owe a bunch of money.” Instead, they affixed a handwritten note to their return that explained that they did not know how to compute the tax and that the “IRS could not help when called.” They asked for a “corrected 1040 explanation + how much is owed.”
As you can imagine, this did not end well for them. According to the Tax Memo, the loans taken “resulted in a policy debt of $237,897.25,” “the termination of the policy in 2011 resulted in the extinguishment of” that debt, and “$150,397.25 (the amount by which the constructive distribution exceeded his investment in the life insurance contract) was includable in their gross income.”
This particular case seems straightforward enough. “Phantom income” will be always be attributed to a taxpayer who allows a life insurance policy to lapse when the debt on the policy exceeds the cost basis, yet, at ITM TwentyFirst, we have seen situations in which trustees have allowed this to occur. After bringing in a portfolio of policies, I once asked a trust advisor about one particular whole life policy with a very large loan and was told not to worry because “that policy has lapsed.” Luckily, with a minimal payment, it was reinstated. If not, it would have resulted in a taxable event of almost $200,000 for a trust that had no cash assets.
In another case, the liability was less transparent and off in the future. A grantor with a portfolio of whole life policies had not been paying anything into the policies for years, allowing loans to pay the premiums. When we took over, we reached out to the agent who said he “had a plan,” essentially allowing the interest and loans to accrue on the policy. When we reviewed the policies, we realized that shortly the portfolio would be in jeopardy, and in short order, cash contributions would have to be made, or taxable lapses would occur. Even with the cash contributions, each year as the loans grew, the net death benefit on the policies would drop. This was not a good situation, and one that could have been avoided with a little educated foresight.
These two cases highlight two types of liabilities for trustees. The first is easy to see (but sometimes is missed); the second can only be seen with a thorough analysis (which is often not done). On Tuesday, September 27, ITM TwentyFirst University will be hosting a free webinar entitled, How Trustees Can Avoid Getting Sued. The session will include the thorough analysis we provided on the second case above as one of the “real life” case studies. The session will provide one hour of continuing education for both CFP and CTFA designations. To sign up, simply click this link: https://www.itm21st.com/Education.