Taxpayer Recognizes Taxable Income on Surrender of Life Insurance Policy

Tax Court concludes that taxpayer recognized taxable income on the surrender of his life insurance policy when the insurance company applied the policy’s maturity value to the outstanding balance of his policy loans.

Download PDFpdf-icon


James Ledger, et ux. v. Commissioner, TC Memo 2011-183.

Facts.  In April of 1974, James Ledger (Ledger) purchased a life insurance policy from Prudential Insurance Co. of America (Prudential).  The policy was payable on the earlier of his death or his reaching age 65.  The face amount of the policy was $31,448, the maturity value considered for gain was $61,722, and the endowment maturity value was $42,403.  Monthly premium payments were $100.

In October of 1978, Ledger borrowed $2,000 against the policy.  Over approximately the next 27 years, he took out 13 additional loans against the policy.  As of May 27, 2005, his final loan balance and accrued interest against the policy totaled $56,220.

The policy matured on April 12, 2006, with a gross maturity value of $61,788, and a maturity value considered for gain value of $61,772.  Prudential paid Ledger $5,568 (which was the gross maturity value less final loan balance).  Prudential determined Ledger’s investment in the contract at the time of maturity to be $20,780, and that policy’s premiums were paid using the annual dividends from 1996 to 2005.

For the 2006 tax year, Prudential issued Ledger a Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) that identified taxable distributions of $40,992 (calculated as maturity value considered for gain less cost basis).  A letter sent by Prudential to Ledger explained how it calculated his cost basis and taxable distributions in the policy.

On December 15, 2008, the IRS issued a notice of deficiency to Ledger, determining a $7,184 deficiency in income tax and a Code Sec. 6662(a) accuracy-related penalty of $1,433 for the 2006 tax year.  Ledger challenged IRS in Tax Court, contending that he should not be taxed on any distribution from Prudential in 2006 because he had already paid taxes on all funds issued to him under the policy.

Applicable Law.  An amount received under a life insurance contract that is not received as an annuity is included in gross income to the extent it exceeds the investment in the contract.  See Code Secs. 72(e)(1)(A); 72(e)(5)(A) and 72(e)(5)(C).  On any given date, the investment in the contract equals the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income.   Code Sec. 72(e)(6).

For federal income tax purposes, loans against a life insurance contract’s cash value are treated as true loans from the insurance company to the policyholder with the policy serving as collateral. Thus, using a policy’s proceeds to satisfy a loan has the same effect as paying the proceeds directly to the policyholder.  Minnis v. Commisioner, 71 TC 1049 (1979); Sanders v. Commissioner, TC Memo 2010-279.

Conclusion.  The Tax Court concluded that Ledger received $40,992 as a constructive distribution, taxable as income in his 2006 tax year. The evidence indicated that upon termination in 2006, the policy’s cash value for tax purposes was $61,772, and Ledger’s investment in the policy was $20,780.

When Prudential terminated Ledger’s policy in 2006, it applied the policy’s maturity value to the outstanding balance on the policy loans.  This was the economic equivalent of Prudential paying Ledger the policy proceeds, including the untaxed inside buildup, with Ledger using most of those proceeds to pay off the policy loans. The constructive distribution was a payment of the policy proceeds and as such was gross income to Ledger to the extent the distribution exceeded his investment in the contract.