Life Insurance and Phantom Income

If you receive money from a life insurance policy because the insured has died, the proceeds will not be taxable to you except in the rare case where you have bought the policy from the owner.

Tax on income is burdensome, but at least you have the income in hand. Income tax on "phantom income," is the worst of both worlds, because you must pay tax on income you do not see. A recent Tax Court case illustrates the horror of phantom income.

Harvey bought a $200,000 insurance policy on the life of his mother, Lillian, to pay estate taxes on her death. He paid the premium for nine years, and then stopped paying. Later premiums were paid from loans against policy cash value increases, under the "automatic premium loan" provision of the policy.

The policy cash value grew to $361,000, and the policy loans grew to $365,000. The insurance company told Harvey that that the policy would lapse unless he paid the overloan amount and the current premium, together about $3,700. Harvey decided the policy was no longer needed, (probably because Lillian's net worth was less) so he did not pay the $3,700 and the policy lapsed.

Harvey received a check for $11,000, representing the total cash value plus a termination dividend and less the amount borrowed on the policy, Harvey also received an information return, Form 1099-R, stating that the difference between the policy loan and the investment in the policy, $135,000, was taxable income to him. He had taxable income of $135,000, and cash of only $11,000.

The IRS claimed that Harvey owed tax on $135,000, and that the capital gains rate did not apply. Harvey sued in the Tax Court, claiming that the gain was capital in nature, not ordinary income. The Tax Court not only denied his claim, but also upheld a negligence penalty for under-reporting his tax liability.

If you own an insurance policy on which you have borrowed to pay premiums, and are thinking of letting it lapse, contact us first for advice. The cost of letting the policy lapse may be more than you think.