Court Opinion

ID: 4337392
Source: CourtListenerOpinion
Date Created: 2018-11-14 03:19:50.402335+00
Date Added: 2024-06-11T14:22:54.951896
License: Public Domain

T.C. Summary Opinion 2008-163

                      UNITED STATES TAX COURT

                KENNETH F. REINERT, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

     Docket No. 24409-07S.            Filed December 23, 2008.

     Kenneth F. Reinert, pro se.

     Rachael J. Zepeda, for respondent.

     GERBER, Judge:   This case was heard pursuant to the

provisions of section 74631 of the Internal Revenue Code in

effect when the petition was filed.   Pursuant to section 7463(b),

     1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 2005, the taxable year in
issue.
                                 - 2 -

the decision to be entered is not reviewable by any other court,

and this opinion shall not be treated as precedent for any other

case.

     Respondent determined a $5,368 income tax deficiency and a

$1,074 accuracy-related penalty under section 6662(a) for

petitioner’s 2005 tax year.     The issues for our consideration are

whether petitioner received gross income of     $21,248.18 because

of the termination of his life insurance policy and whether he is

liable for an accuracy-related penalty under section 6662(a).

                           Background2

        At the time his petition was filed, petitioner resided in

Arizona.     On July 17, 1958, petitioner purchased a life insurance

policy with the Northwestern Mutual Life Insurance Co.

(Northwestern).     The face amount of the policy was $10,000, and

the $52.40 premium was payable every 4 months until July 17,

2035, or until petitioner’s 65th birthday, at which time the

policy would be fully paid.     The policy had a cash surrender

value which continued to increase.

        As the cash value increased, petitioner borrowed against

that value.     As of 2005 the cash value of the policy was

$29,933.78.     At the same time, petitioner’s outstanding loan

balance against the cash value was $28,492.40, and the premiums

     2
       The parties’ stipulation of facts and exhibits is
incorporated by this reference.
                               - 3 -

he paid totaled $8,685.60.   Over the years petitioner was not

paying interest on the loans outstanding against the cash value

of the insurance policy, and Northwestern treated the interest on

the loans, under the terms of the policy, as additional loans

against the cash value of the policy.

     Under the policy, “If indebtedness equals or exceeds the

cash value at any time, his policy shall terminate thirty-one

days after a notice of termination has been mailed to the last

known address of the Owner”.   The policy terms also provided that

“Upon receipt at the Home Office of this policy and of a full and

valid surrender of all claims, the insurance shall terminate and

the Company will pay, as directed, the cash value less any

indebtedness.”   At the end of December 2004, Northwestern sent

petitioner a notice that the loan amount would soon exceed the

cash value and that the policy would “terminate”.    The notice

also advised that termination would trigger a taxable event and

would result in reportable ordinary income.   At that point

petitioner owed $1,356.78 interest on his loan against the cash

value of the policy and chose not to pay the interest, resulting

in the loan balance exceeding the cash value of the policy.

Petitioner advised Northwestern that if the policy “terminated”

it was not a taxable event, whereas if the policy was

“surrendered” it was a taxable event.   Petitioner chose not to
                                 - 4 -

pay the interest, the loan amount exceeded the policy cash value,

and the policy was terminated.    Petitioner did not physically

surrender the policy.

     On February 21, 2005, petitioner received a form entitled

“Surrender of Policy for Cash Value” along with a $1,269.57 check

from Northwestern representing the residual cash value after

considering petitioner’s outstanding loan balance.    Petitioner

signed the form and endorsed and cashed the $1,269.57 check.

     Because of the termination, petitioner lost the $10,000 of

life insurance coverage.   In January 2006 petitioner received a

Form 1099-R, Distributions From Pensions, Annuities, Retirement

or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for his

2005 tax year from Northwestern reflecting a gross distribution

of $29,933.78 and a taxable amount of $21,248.18.    The difference

between the gross distribution and the taxable amount was

$8,685.60, the total amount petitioner had paid in premiums on

the policy.

     Petitioner believes that Northwestern used the termination

as leverage to force policy holders to pay interest on their

outstanding loans borrowed against the cash surrender value of

their policies.   In other words, petitioner had $10,000 of fully

paid life insurance in force and had borrowed all of the

increases in cash surrender value to a point where the annual

increases in policy value paid the interest on petitioner’s
                                 - 5 -

outstanding policy loans.    In that way, the insurance company did

not collect interest on the loans, and, because petitioner was 65

years old (making his policy paid up), he made no more premium

payments.

                             Discussion

     Petitioner allowed his policy to terminate by not paying the

interest on outstanding loans so that the loan balance exceeded

the threshold for termination.    Petitioner contends that a

“termination” of a policy in this manner is not a taxable event

because the pertinent statutes and regulations expressly apply to

a “surrender” of a policy.

     Section 72(e)(1)(A)(i), (5)(A), and (C) generally provides

that an amount received in connection with a life insurance

contract, which is not received as an annuity, constitutes gross

income to the extent that the amount received exceeds the

investment (basis) in the insurance contract.   Section

72(e)(6)(A) generally provides that the “investment” in the

contract is the aggregate amount of premiums.

     In particular, and as pertinent to this case, section 1.72-

11(d)(1), Income Tax Regs., provides

     Any amount received upon the surrender, redemption, or
     maturity of a contract to which section 72 applies,
     which is not received as an annuity under the rules of
     paragraph (b) of § 1.72-2, shall be included in the
     gross income of the recipient to the extent that it,
     when added to amounts previously received under the
     contract and which were excludable from the gross income
     of the recipient under the law applicable at the time of
                                - 6 -

     receipt, exceeds the aggregate of premiums or other
     consideration paid. * * *

     Petitioner argues that his insurance policy contract was

“terminated” and that he did not literally “surrender” the

policy.   He relies on dictionary definitions of those terms;

i.e., a “termination” in the setting of his case is an

involuntary event, whereas a “surrender” is a voluntary act that

he did not perform.    Because the statute and the regulations use

the term “surrender” and the term “termination” is absent,

petitioner argues that Congress intended that amounts received in

excess of investment on account of termination are not includable

in his gross income.   Petitioner has not provided any reference

to legislative history in support of his contention.     Petitioner

does not question the amounts in dispute, only the legal question

of whether the excess over investment is taxable.

     We addressed a substantially similar set of circumstances in

Atwood v. Commissioner, T.C. Memo. 1999-61.     In that case, as

with petitioner, the insurance contracts provided for the

termination or lapse of the policy when the total loan, including

unpaid interest, exceeded the policy cash value or a similar

threshold.   Likewise in Atwood, the taxpayers failed to repay any

portion of the loans or interest thereon.     Their insurance policy

contracts were terminated, and they were sent a small check

reflecting the amount of the cash surrender value after

considering the outstanding loans.      In Atwood, as in petitioner’s
                               - 7 -

case, the termination resulted in the outstanding loan’s being

satisfied by the cash value of the policy.   In Atwood the excess

of the cash surrender value over the total premiums was held to

be ordinary income.

     The cash value of petitioner’s insurance policy increased

from its 1958 inception to the time of termination by $29,933.78.

No amount of that increase in value was distributed to petitioner

as a dividend or distribution and, as a result, petitioner paid

no tax on the increase between 1958 and 2005.   During that same

period petitioner paid $8,685.60 in premiums on the life

insurance policy and borrowed $28,664.21 (representing principal

and interest).   As of 2005 petitioner had attained the age of 65,

no further premiums were due, and his life insurance policy was

considered fully paid.

     After petitioner was warned by Northwestern that his

outstanding loans and interest were going to exceed the amount

that would result in termination under the terms of the life

insurance contract, he decided to allow the termination.    In

response, Northwestern sent petitioner a $1,269.57 check

representing the difference between the $29,933.78 cash value of

the policy and petitioner’s $28,664.21 outstanding loan

(including interest accretions) against the cash value.

Northwestern sent petitioner a Form 1099-R reflecting the above

information and advising petitioner that $21,248.18 was
                                 - 8 -

includable in his 2005 income.    The $21,248.18 represents the

$29,933.78 cash value less petitioner’s investment/basis of

$8,685.60 in premiums paid.

     Although petitioner complains that he received only

$1,269.57 and he did not “surrender” his policy,3 when the policy

terminated, petitioner was relieved of $28,664.21 in outstanding

loans which he had taken out during the 47 years the policy was

in force.   So, in effect, he received $29,933.78, $1,269.57 in

cash and $28,664.21 in payment or credit against his outstanding

loan obligations.   Petitioner could have further deferred

reporting this income by paying interest on or reducing the

principal of his loan to an amount that would not have caused

termination.   In addition, he could have maintained his paid-up

life insurance coverage by maintaining the loan balance below the

threshold amount.

     Section 72(e) causes the increases in value of insurance

contracts to be taxable when the policy ends prior to the payment

of an annuity.   This situation is one that permits the deferral

of the reporting of income until a triggering event occurs.       We

see no distinction between the termination and surrender of an

insurance policy for this purpose.       The physical act of

     3
       We note that although petitioner may not have physically
surrendered his policy, he did sign a form entitled “Surrender of
Policy for Cash Value” in order to negotiate the $1,269.57 check
from Northwestern.
                               - 9 -

submitting the policy is of no import in this setting.    The

policy has been terminated and no contractual relationship

continued between petitioner and Northwestern.    In reality,

petitioner was allowed to defer the increases in value of his

policy for many years, a fact that he fails to focus upon.      We

accordingly hold that petitioner had $21,248.18 of income as

determined by respondent.

     Respondent also determined that petitioner was liable for an

accuracy-related penalty under section 6662(a) on the

underpayment of tax for his 2005 tax year.    Section 6662(a)

imposes a 20-percent penalty on the portion of an underpayment of

tax attributable to, among other things, a substantial

understatement of income tax, which is defined in section

6662(d)(1)(A) as an understatement that exceeds the greater of 10

percent of the tax required to be shown or $5,000.    Petitioner

reported $2,853 of tax and accordingly his tax was understated in

the amount of $5,368, an amount that is more than 10 percent of

the tax required and also more than $5,000.

     Petitioner would therefore be subject to the penalty unless

he can show that any part of the understatement is attributable

to an item that was adequately disclosed and has a reasonable

basis, or for which there was substantial authority for its tax

treatment.   Sec. 6662(d)(2)(B).
                              - 10 -

     Petitioner, although issued a Form 1099-R by Northwestern

indicating taxable distributions upon termination of his

insurance policy, made no disclosure on his income tax return of

the Form 1099-R from Northwestern or explanation as to why the

amounts shown thereon were not reported on his 2005 return.      See

sec. 6662(d)(2)(B)(ii)(I).   Petitioner has argued that a

termination was not contemplated but has not shown any authority,

substantial or otherwise, for excluding these amounts from

income.

     We accordingly hold that petitioner is liable for the

accuracy-related penalty, as determined by respondent.

     To reflect the foregoing,

                                      Decision will be entered

                                 for respondent.