Brown v. Commissioner

In the
United States Court of Appeals
For the Seventh Circuit
No. 11-2508
B RUCE A. B ROWN and C AROL A NFINSON B ROWN,
Petitioners-Appellants,
v.
C OMMISSIONER OF INTERNAL R EVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court
No. 6825-08—Richard T. Morrison, Judge.
A RGUED M AY 25, 2012—D ECIDED S EPTEMBER 11, 2012
Before P OSNER, FLAUM, and W OOD , Circuit Judges.
P OSNER, Circuit Judge. The Tax Court ruled that the
petitioners, a married couple filing a joint return, had
underpaid federal income tax for 2005 by $8,553. The
court assessed a deficiency equal to that amount and
tacked on a penalty of $1,711 (20 percent of the deficiency,
the IRS apparently having rounded off $1710.60 to $1711).
The basis of the deficiency was the taxpayers’ failure
to include in their taxable income for that year income
2 No. 11-2508
realized by Mr. Brown upon the cancellation of a $100,000
life insurance policy that he owned, a whole life policy
issued to him by Northwestern Mutual Life Insurance
Company in 1982. In such a policy the insured pays a
constant annual premium and the policy pays the same
death benefit whenever he dies. Since he is more likely
to die when he gets older yet the policy premiums
don’t increase as he ages, the insurance company must
charge a premium that produces an overcharge in the
early years in order to build up a store of value that
will defray the cost of paying the death benefit in later
years, which is when death is more likely, and the
death benefit therefore more likely to become payable,
than in the earlier years. The sum of the overcharges is
called the policy’s “cash value,” and the policyholder can
borrow against it either for personal reasons or to pay
future premiums. Alternatively, by canceling the policy,
which he can do at any time, he is entitled to receive the
cash value (called in that event the “cash surrender” value)
less any outstanding loans against it. See 1 Robert H. Jerry,
II, New Appleman on Insurance Law Library Edition,
§ 1.08(b)(ii) (2012). He is also entitled to the cash sur-
render value if the insurance company, rather than
he, cancels the policy, as the company is entitled to do
if his borrowing from the company exceeds the cash
value—in which event, however, he will owe the
company more than it owes him.
An insurance company doesn’t just sit on a policy-
holder’s premium payments, of course; it invests them;
and as is the practice of mutual insurance companies,
No. 11-2508 3
Northwestern Mutual credits part of the income from
investing them to the policyholder’s account with the
company and calls these credits “dividends.” Northwest-
ern Mutual, “Company Overview: What Mutuality
Means to You,” www.northwesternmutual.com/about-
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. 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 policy required an annual premium of $1,837.
From 1982 to 1986 Brown paid in cash, but from 1987
to 2000 he paid by borrowing against the policy’s cash
value, with the result that his indebtedness to the insur-
ance company increased. From 2001 through 2003, with
his indebtedness approaching the policy’s cash value,
he paid half the premiums in cash and the rest by bor-
rowing from the company. Nevertheless in 2004 his
indebtedness exceeded the policy’s cash value, and he
surrendered the additional insurance that he had ob-
tained by applying his dividends to the purchase of addi-
tional insurance and he directed that future dividends
be used to pay premiums and pay back his accumulated
4 No. 11-2508
debt to the company. But by the end of 2005 the amount
he had borrowed from the insurance company again
exceeded the policy’s cash value (though only by
$30.42), and this time the insurance company cancelled
the policy, as the terms of the policy entitled it to do.
The $31,063.30 of additional insurance that Brown
surrendered in 2004 and the $4,869.94 of dividends sub-
sequently 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
No. 11-2508 5
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 volun-
tarily 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 sub-
tracting 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), af-
firmed on other grounds, 438 Fed. Appx. 686 (10th Cir.
2010).
6 No. 11-2508
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 in-
surance policies. It is captioned “special rules for ap-
plication 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 de-
ductible. 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).
The Tax Court’s result may seem odd because it
seems not to account for the cost that Brown (and the
beneficiary of the life insurance policy, his wife) incurred
when he was credited, upon cancellation of the policy,
with the policy’s cash surrender value. The cost incurred
was the value of the death-benefit component of the
No. 11-2508 7
policy, which (obviously) evaporated when the policy
was cancelled.
But the oddness is superficial. As time passes and the
cash surrender value of a whole-life policy grows, the
net death benefit, which is the face amount of the
policy (the proceeds on death) minus the premiums
paid, shrinks as a result of the growing stock of premiums
paid, to the point at which further premium payments
(which remember were fixed at $1,837 a year) can
actually reduce the net death benefit. By surrendering
the policy (albeit involuntarily) Brown gave up the pros-
pect of receiving $100,000 if he died but at the same
time freed himself from having to pay $1,837 each year
to maintain that prospect.
It remains only to consider the penalty for the under-
statement 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, con-
gressional 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).
There is a compelling reason for limiting the eligible
authorities as tightly as the regulation does: otherwise
8 No. 11-2508
demand by taxpayers would evoke “authorities” for every
position that a taxpayer might wish to take. The
authorities on which the taxpayers in this case rely
either do not support their position or aren’t on the list.
Even if there isn’t substantial authority in support of a
taxpayer’s position, he can avoid the underpayment
penalty if he made reasonable efforts to determine his
tax liability. 26 U.S.C. § 6664(c); Treas. Reg. §§ 1.6662-4(a),
1.6664-4(b). Generally this requires that he have ob-
tained an opinion from an accountant or lawyer. United
States v. Boyle, 469 U.S. 241, 250-51 (1985); Mulcahy,
Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d 867,
872 (7th Cir. 2012). The taxpayers in this case are an
attorney couple who made no effort to research the
legal basis for their position, or obtain an opinion from
an accountant or lawyer, until the Internal Revenue
Service challenged their position. So they didn’t reach
the safe harbor.
A FFIRMED.
9-11-12