In the case of Doggart v. Commissioner,[1] a taxpayer lodged a complaint, arguing that they couldn’t have taxable income for the year 2017 since they did not receive any cash during that period. However, the taxpayer will soon discover that this assumption does not necessarily hold true when dealing with a lapsed life insurance policy coupled with outstanding loans taken against the cash value of the policy.

Facts of the Case

In this case the taxpayer faced a major event in his life in 2017, beginning a period of incarceration.

On February 16, 2017, petitioner was incarcerated. He remained incarcerated through the time of trial. Petitioner resided at his home in Signal Mountain, Tennessee (Signal Mountain Property), for some years before 2017 and through February 16, 2017.[2]

The opinion describes the life insurance policies that would serve as the items of interest in this case, as well as the various events related to those policies that took place in 2017.

Before 2017 petitioner took out a series of loans against two life insurance policies that he held with Prudential Insurance Co. of America (Prudential). The cash value of his policies served as collateral for the loans. While incarcerated, petitioner stopped paying premiums on the two policies. As a result, each policy lapsed and Prudential used the cash values of the policies to repay the loans plus interest due. Prudential subsequently issued petitioner Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for 2017 with respect to each policy and reported taxable distributions from life insurance to the Internal Revenue Service (IRS). The amounts reported as taxable on the Forms 1099-R were $13,214 and $5,366, calculated with respect to each policy as the outstanding loan amount repaid by the cash value of the policy less the total premiums petitioner paid with respect to the policy. Upon inquiry by petitioner, Prudential issued to petitioner a letter dated September 1, 2021, with respect to each policy explaining these calculations.[3]

Despite having income reported from life insurance policies and other income streams, Mr. Doggart neglected his 2017 income tax return obligations. His failure to file caught the attention of the Internal Revenue Service, prompting further examination of his activities.

Petitioner failed to file an income tax return for the 2017 tax year and to make estimated tax payments or otherwise fully pay his tax due. Petitioner also failed to file an income tax return for the 2016 tax year. On or around March 9, 2020, the IRS prepared a substitute for return (SFR) pursuant to section 6020(b) for petitioner’s 2017 tax year. On November 30, 2020, respondent issued petitioner a notice of deficiency for the 2017 tax year, which, inter alia, included in petitioner’s gross income the taxable distribution amounts reported by Prudential. On February 25, 2021, while residing in Kentucky, petitioner timely filed a Petition with this Court.[4]

Even Though No Cash Was Received in 2017, Income is Generated by the Policies

Mr. Doggart claimed a lack of income in 2017. He substantiated his claim by asserting that he received no funds from Prudential within that year:

Petitioner contends that termination of his life insurance policies should not result in income for the 2017 tax year because he did not actually receive any money at the time the policies were terminated. Petitioner argues that distributions were instead taxable, if at all, when he initiated the loans with Prudential and received cash.[5]

The Court initiates its analysis by delineating the manner in which a life insurance policy can potentially result in taxable income.

Gross income includes income derived from life insurance contracts. §61(a)(9); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955). Amounts received from life insurance contracts other than as a death benefit or annuity are included in gross income to the extent that they exceed the investment in the contract. §§72(b), (e)(1)(A), (5)(A), (C), 101(a). The “investment in the contract” is the aggregate amount of the premiums paid less amounts previously received as income from the contract but excluded from gross income calculations. §72(e)(6).[6]

While this taxable income could be prompted when a policyholder receives a payout exceeding their investment in the contract, it can also be induced by a constructive distribution. This occurs when the cash value of the policy is utilized to settle any outstanding loans held against it.

A taxpayer can receive a constructive distribution from the termination of his life insurance policy, which must be included in gross income, even if the taxpayer does not physically receive cash or other property from the policy during the tax year. Black v. Commissioner, T.C. Memo. 2014-27, at *8-9; Brown v. Commissioner, T.C. Memo. 2011 83, slip op. at 10-12, aff’d, 693 F.3d 765 (7th Cir. 2012); Sanders v. Commissioner, T.C. Memo. 2010-279, slip op. at 2-6; McGowen v. Commissioner, T.C. Memo. 2009-285, slip op. at 7-12, aff’d, 438 F. App’x 686 (10th Cir. 2011); Barr v. Commissioner, T.C. Memo. 2009-250, slip op. at 3; Atwood v. Commissioner, T.C. Memo. 1999-61, slip op. at 4-6. The termination of both a life insurance policy and indebtedness against the policy functions as the application of the cash value of the insurance policy against the debt owed. McGowen, T.C. Memo. 2009 285, slip op. at 8-12. The application of the cash value of a life insurance policy against an outstanding loan is no different from distributing the proceeds of the policy to the taxpayer to permit the taxpayer to use those proceeds to pay off the loan. Feder, T.C. Memo. 2012-10, slip op. at 11. A constructive distribution is included in gross income insofar as it exceeds the taxpayer’s investment in the life insurance contract. Sanders, T.C. Memo. 2010-279, slip op. at 5.[7]

In this instance, the constructive distribution was triggered when the cash value was leveraged to offset loans after the taxpayers discontinued their premium payments. The reduction of the policy's value to an amount equal to the cash value, owing to the incurred policy expenses, prompted a policy surrender. This essentially means that the remaining cash value was then applied to settle outstanding policy loans.

When petitioner stopped paying the premiums on his two life insurance policies, Prudential notified him that the lack of payments resulted in the termination of his loans and underlying policies. The terminations effectively applied the cash values of his policies against the loans in extinction of both. Petitioner's investment in the two contracts is equal to the sum of his premiums paid. When the policies were terminated and the cash values of the policies were taken to repay the loans, petitioner constructively received the cash values of the policies. The amounts constructively received in excess of his investments in the contracts are therefore includible in gross income. Accordingly, we conclude that petitioner, who disputes neither the amounts of the loans extinguished by the policies' cash values nor the amounts of his investments in those policies, received and failed to report life insurance income from the two lapsed policies as Prudential calculated.[8]

As highlighted in the judgment, employing an asset that carries unrecognized income to extinguish a loan activates the release of such unacknowledged income inherent within the insurance policy.

Petitioner has not, however, argued or otherwise shown that his policy loans were not true loans. And it is well established that the receipt of cash in the form of a bona fide loan does not constitute income so long as an obligation to repay the borrowing remains. Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 207-08 (1990); Commissioner v. Tufts, 461 U.S. 300, 307 (1983). Loans taken out against life insurance policies can constitute bona fide loans. Black, T.C. Memo. 2014-27, at *8. Because petitioner’s borrowings had an obligation of repayment at the time they were taken, they did not constitute income when initially received. While petitioner did not physically receive money upon the lapse of his policies, he no longer had to repay the loans, so it is “irrelevant that no money changed hands.” Brown v. Commissioner, 693 F.3d at 768. As physical receipt of cash does not dictate taxability, the initial disbursement of the loans was not taxable. Likewise, the lack of distribution of cash to petitioner does not render untaxable the termination of his life insurance policies.[9]

[1] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/lapsed-life-insurance-policies-leave-individual-with-taxable-income/7h0w0 (retrived July 29, 2023)

[2] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[3] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[4] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[5] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[6] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[7] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[8] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023

[9] Doggart v. Commissioner, TC Summary Op. 2023-25, July 27, 2023