Source: http://caselaw.findlaw.com/us-7th-circuit/1611670.html
Timestamp: 2018-03-23 20:33:12
Document Index: 366249222

Matched Legal Cases: ['§ 72', '§ 72', '§ 72', '§ 72', '§ 61', '§ 163', '§ 6662', '§ 6662', '§ 1']

BROWN v. COMMISSIONER OF INTERNAL REVENUE | FindLaw
Before POSNER, FLAUM, and WOOD, Circuit Judges.Carol L. Anfinson, Attorney, Aurora, IL, for Petitioners–Appellants. Robert W. Metzler, Attorney, Tamara W. Ashford, Attorney, Department of Justice, Washington, DC, for Respondent–Appellee.
An insurance company doesn't just sit on a policyholder's premium payments, of course; it invests them; and as is the practice of mutual insurance companies, Northwestern Mutual credits part of the income from investing them to the policyholder's account with the company and calls these credits “dividends.” Northwestern Mutual, “Company Overview: What Mutuality Means to You,” www.northwesternmutual.com/a bout-northwestern-mutual/our-company/company - overview.aspx# Mutuality (visited Aug. 21, 2012); see Indianapolis Life Ins. Co. v. United States, 115 F.3d 430, 431 (7th Cir.1997); Prairie States Life Ins. Co. v. Un United States, 828 F.2d 1222, 1223–24 (8th Cir.1987). Brown's policy gave him a choice among receiving his dividends in cash, using them to pay future premiums, or—the default option specified in the policy—buying additional life insurance above the face amount of the policy ($100,000 in Brown's policy). Because he made no selection among these alternatives, by default the dividends were used to increase his life insurance.
The $31,063.30 of additional insurance that Brown surrendered in 2004 and the $4,869.94 of dividends subsequently applied at his direction to pay premiums and repay debt in that and the following year are at the heart of the litigation. The position of the Internal Revenue Service, seconded by the Tax Court, is that these moneys (totaling $35,933.24) are value that Brown received from the policy before it was cancelled. Therefore they reduce by this amount his net “investment in the [insurance] contract” (the sum of all premiums that the policyholder paid minus any amounts he received before he surrendered the policy upon its cancellation by the insurance company or by his own choice, 26 U.S.C. § 72(e)(6)). That is a reduction in net investment from $44,205.00 to $8,271.76 ($44,205.00—$35,933.24). According to the terms of the policy, the policy had a cash value of $37,356.06 at the time of surrender.
An investment of $8,271.76 that makes the policy worth $37,365.06 on surrender generates $29,093.30 ($37,365.06—$8,271.76) in taxable income. But Brown contends that really he invested the full $44,205 in the contract (the policy) within the meaning of the applicable tax law—that that amount should not be diminished by the $35,933.24 in additional insurance and dividends received—and that therefore he realized a net loss when the policy was cancelled, and so no tax is due. Naturally he is loath to pay any tax in respect of the cancellation, since he received no money from it.
The cash value of a surrendered (whether or not voluntarily surrendered) life insurance policy is includable in gross income “to the extent it exceeds the [taxpayer's] investment in the [insurance] contract,” 26 U.S.C. § 72(e)(5)(A), and is taxable as ordinary income. Barr v. Commissioner, No. 8705–08, 2009 WL 3617587, at *3 (U.S.Tax Ct. Nov.3, 2009); see also Wolff v. Commissioner, 148 F.3d 186, 189–90 (2d Cir.1998). When Brown's policy was cancelled, its cash value was $37,365.06. What had he invested in the policy? That is, what was his cost (his “basis,” in tax-speak)? Remember that he had paid a total of $44,205.00 in premiums but had received $35,933.24 from surrendering the additional insurance in 2004 and from using dividends to pay premiums and loans in 2004 and 2005. The difference of $8,271.76 was the net cost to him of the cash surrender value of the policy, and subtracting the $8,271.76 cost from that value resulted in taxable gross income of $29,093.30, just as the Tax Court ruled, even though Brown had received no cash because the cash value of the policy had been used to pay off the loans that he had gotten from the company to pay for his premiums. E.g. Feder v. Commissioner, No. 1628–10, 2012 WL 75114, at *4 (U.S.Tax Ct. Jan.10, 2012); Sanders v. Commissioner, No. 3395–09, 2010 WL 5327897, at *2 (U.S.Tax Ct. Dec.20, 2010); McGowen v. Commissioner, No. 14116–07, 2009 WL 4797538, at *4 (U.S.Tax Ct. Dec.14, 2009), affirmed on other grounds, 438 Fed.Appx. 686 (10th Cir.2010).
Brown claims that the $35,933.24 in additional insurance and dividend payments was (or was equivalent to) “dividends ․ retained by the insurer as a premium or consideration paid for the [insurance] contract,” which 26 U.S.C. § 72(e)(4)(B) excludes from gross income. But that section is inapplicable to payments under life insurance policies. It is captioned “special rules for application of paragraph (2)(B),” and that paragraph does not apply to non-annuity life insurance payments. 26 U.S.C. §§ 72(e)(5)(C), (e)(5)(A)(i).
The gross income calculated by the Tax Court was the amount by which the cash value of Brown's insurance policy exceeded what he'd paid for the policy. The fact that this income was used to pay a debt to the insurance company is irrelevant, because it was a personal rather than a business debt and therefore was not deductible. 26 U.S.C. § 61(a); 26 U.S.C. §§ 163(a), (h); Kikalos v. Commissioner, 190 F.3d 791, 793–94 (7th Cir.1999). It is also irrelevant that no money changed hands-that the debt was paid by the creditor's withholding money otherwise due the debtor, like a setoff. See, besides the Feder, Sanders, and McGowen opinions cited above, Barr v. Commissioner, supra, 2009 WL 3617587, at *2, and Atwood v. Commissioner, No. 19748–97, 1999 WL 109617, at *2 (U.S.Tax Ct. Mar.4, 1999).
It remains only to consider the penalty for the understatement of tax. The 20 percent penalty for substantial understatement of income tax, 26 U.S.C. §§ 6662(a), (b)(2), (d), has an exception for the case in which the taxpayer's position was supported by “substantial authority.” § 6662(d)(2)(B)(i); see Kim v. Commissioner, 679 F.3d 623, 626 (7th Cir.2012); TIFD III–E, Inc. v. United States, 666 F.3d 836, 848–50 (2d Cir.2012). As defined with great specificity in a Treasury Regulation the validity of which is not challenged, the term “substantial authority” is limited to statutes, regulations, judicial decisions, congressional floor statements and committee reports, revenue rulings and procedures, tax treaties, private letter rulings, and certain IRS publications. Treas. Reg. § 1.6662–4(d)(3)(iii).