Reinert v. Comm'r

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.
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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.
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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
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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
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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
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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
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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
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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.
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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).
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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.