David Byron Fugler and Cindy Diane Fugler v. Commissioner of Internal Revenue

The Phantom Income Trap

Surrendering a life insurance policy can trigger a nasty tax surprise, as David and Cindy Fugler discovered. Despite receiving less than $6,000 in cash, the couple faced a tax bill on over $32,000 of taxable income, the result of the policy surrender satisfying outstanding loans. The Tax Court sided with the IRS, finding the income taxable in 2018 and denying deductions for interest on the policy loans. This serves as a stark warning: even experienced attorneys can fall victim to the phantom income trap lurking within life insurance policies.

From Whole Life to Whole Debt

Continuing the story of the Fuglers' tax predicament... In 1987, David Fugler purchased two whole life insurance policies from Massachusetts Mutual Life Insurance Co. (Mass Mutual), one for each of his children. He applied for the first policy on December 14, 1987, and Mass Mutual issued a policy with a face amount of $16,394. Fugler paid $2,500 for this first policy, including the initial premium and an Additional Life Insurance Rider. Annual premiums were set at $150 until the child's 65th birthday. He purchased the second policy on December 28, 1987, with a face amount of $18,692, also paying $2,500 that included the initial premium and rider. Its annual premiums were similarly $150. From 1988 through 2006, Fugler dutifully paid the $150 annual premiums for each policy.

The policies allowed Fugler to borrow against their cash surrender value, with a flexible interest rate capped at 8% per year. Unpaid interest was added to the loan balance and also subjected to interest. On August 29, 2006, Fugler borrowed $10,500 from the first policy and $11,000 from the second.

Starting in 2007, Fugler ceased paying the annual premiums out-of-pocket. Instead, from 2007 through 2016, he borrowed from the policies to cover the $150 annual premiums. The interest on these borrowed premiums was then added to the loan balance. By February 14, 2018, the loan balances had ballooned. For the first policy, the initial $10,500 loan, $1,500 in premiums paid via loan, and $7,125 in capitalized interest (plus $720 in uncapitalized interest from 2017) brought the total loan balance to $19,845. The second policy's balance reached $20,699, comprised of the initial $11,000 loan, $1,500 in premiums paid via loan, $7,448 in capitalized interest, and $751 in uncapitalized interest.

In January 2018, Fugler decided to terminate both policies. He notified Mass Mutual, which acknowledged his decision and sent surrender forms, advising him that the surrender could result in taxable income. On January 29, 2018, Fugler submitted the forms, and Mass Mutual terminated the policies on February 14, 2018. Fugler received two checks: $3,033 for the first policy's cash surrender value and $2,729 for the second. Mass Mutual also issued Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for each policy. The 1099-Rs reported a gross distribution of $22,878 for the first policy, with a taxable amount of $16,028, and a gross distribution of $23,428 for the second policy, with a taxable amount of $16,578. The gross distribution included both the cash paid to Fugler and the outstanding loan balance. The taxable amount was calculated by reducing the gross distribution by the $6,850 of premiums paid for each policy (either directly or via loan).

Constructive Receipt: Why Loan Forgiveness is Income

The Tax Court addressed whether distributions from the life insurance policies were includable in the Fuglers' 2018 income. At issue was $32,606 of taxable income resulting from the termination of two life insurance policies with outstanding loan balances.

In 2006, the Fuglers took out loans against two life insurance policies, receiving $10,500 and $11,000, respectively. On February 14, 2018, the Fuglers terminated the policies. They received checks for the remaining balance of each policy, but the outstanding loan balances were satisfied using the policies' available proceeds. The IRS determined that the combination of the checks received and the loan balances satisfied constituted taxable income.

The Fuglers argued that if the termination of the loans resulted in taxable income, that income should be attributed to 2017, not 2018. They based this argument on an "effective date" provision within the policies, which they contended deemed the terminations effective in 2017.

The IRS countered by citing Section 61(a), which defines gross income as income "from whatever source derived," including "[i]ncome from life insurance and endowment contracts." Further, Section 72(a)(1) provides that gross income includes any amount received under an annuity, endowment, or life insurance contract. For nonannuity contracts, Section 72(e)(1)(A) and (3) dictate that amounts received are included in gross income to the extent they exceed the investment in the contract. The IRS explained that while a policy loan is not initially a taxable event, when the policy is surrendered, the satisfaction of that loan constitutes a 'receipt' by the taxpayer.

The court sided with the IRS. The court explained that a loan against a life insurance policy's cash value is treated as a loan from the insurance company to the policyholder and is not a taxable distribution when the funds are received. However, a taxpayer constructively receives proceeds from a terminated life insurance policy to the extent that existing policy loans are satisfied with the policy's available proceeds.

The court found that the policies were terminated on February 14, 2018, and the loan balances were paid off and checks were cut on that day. The court then cited Section 451(b)(1)(C), which governs the tax year for which income is included. Since the Fuglers requested termination of the policies in January 2018 and received the proceeds in February 2018, the resultant income from the terminations was includible in their 2018 income, regardless of their method of accounting. Thus, the court concluded that the proceeds that petitioners actually received (the checks) as well as the proceeds that petitioners constructively received (the amounts used to satisfy the outstanding policy loan balances) represent taxable income to petitioners in 2018 to the extent that the proceeds exceeded the premiums paid.

Logging, Mining, and Innocent Husbands

The court then addressed the petitioners' claim for an interest expense deduction and a request for equitable relief under Section 6015(f).

The petitioners argued that the loan interest was deductible because the proceeds were used in connection with a "mining and logging" business. However, the IRS contended that the interest was nondeductible personal interest. Section 163(a) generally allows a deduction for "all interest paid or accrued within the taxable year on indebtedness." However, Section 163(h) disallows a deduction for personal interest. Personal interest is defined in Section 163(h)(2) as any interest other than interest paid or accrued on indebtedness properly allocable to a trade or business (excluding the trade or business of performing services as an employee), investment interest, interest taken into account under Section 469 in computing income or loss from a passive activity, qualified residence interest, interest payable under Section 6601 on unpaid estate tax, and interest on educational loans deductible under Section 221.

While the court acknowledged that interest "paid or accrued on indebtedness properly allocable to a trade or business" is not considered personal interest, the court found the petitioners failed to provide sufficient evidence to support their claim. Aside from vague testimony, they offered no evidence showing that either Mr. Fugler was engaged in a mining and logging business in 2018, or that the loan proceeds were actually used in such a business. Consequently, the court determined the petitioners failed to demonstrate that the interest paid on the policy loans was anything other than nondeductible personal interest, and the deduction was denied.

Finally, the court considered Mr. Fugler's request for equitable relief under Section 6015(f). Section 6015(f) provides that under procedures prescribed by the IRS, if a taxpayer making a joint return is relieved of liability, pursuant to such procedures, it is appropriate to do so. As the court noted, the IRS conceded that Mrs. Fugler was entitled to relief under Section 6015(b), which provides relief to a spouse when there is an understatement of tax on a joint return attributable to erroneous items of one individual. Nevertheless, the petitioners argued that the court had the authority to grant Mr. Fugler relief from the federal income tax consequences resulting from the termination of the life insurance loans.

The court disagreed, stating that it would "offend common sense" to allow both spouses Section 6015 relief with respect to the same income tax liability. The court noted that Section 6015 relief is generally available to only one spouse for a single tax year, and is intended to protect one spouse from the overreaching or dishonesty of the other spouse. The court implied that Mr. Fugler was the primary actor in the events leading to the tax liability, making him ineligible for equitable relief.

The Cost of Surrender

...The court disagreed, stating that it would "offend common sense" to allow both spouses Section 6015 relief with respect to the same income tax liability. The court noted that Section 6015 relief is generally available to only one spouse for a single tax year, and is intended to protect one spouse from the overreaching or dishonesty of the other spouse. The court implied that Mr. Fugler was the primary actor in the events leading to the tax liability, making him ineligible for equitable relief.

The Cost of Surrender

Life insurance policies can present unexpected tax consequences when surrendered, especially if loans are involved. The recent case of Fugler v. Commissioner serves as a stark reminder of this potential pitfall. The core issue revolves around how the IRS and the Tax Court treat the surrender of a life insurance policy with an outstanding loan balance.

In Fugler, the taxpayer surrendered a life insurance policy that had an outstanding loan against it. While the taxpayer may have received a relatively small amount of cash upon surrender, the IRS argued that the entire loan balance that was satisfied by the insurance company constituted taxable income.

The IRS based its argument on the principle of constructive receipt and Section 72(e), which governs the tax treatment of amounts received from life insurance contracts that are not annuities. Specifically, Section 72(e)(5)(A) states that amounts received upon surrender are included in gross income only to the extent they exceed the "investment in the contract." The "investment in the contract," as defined in Section 72(e)(6), is essentially the aggregate premiums paid, minus any prior nontaxable distributions.

The IRS argued that when the insurance company used the policy's cash value to pay off the outstanding loan, it was the same as the taxpayer receiving cash and then using that cash to pay off the debt. Thus, the taxpayer constructively received the loan amount. The IRS then subtracted the taxpayer's "investment in the contract" (premiums paid) from the total distribution (cash received plus loan satisfied) to determine the taxable gain.

The Tax Court agreed with the IRS. It has repeatedly held that the discharge of a life insurance loan upon surrender is indeed a taxable event, even if the policyholder receives little to no actual cash at the time of surrender. This is because the loan satisfaction is considered a distribution from the policy.

The Fugler case, and others like Doggart v. Commissioner, highlight a crucial lesson for taxpayers: surrendering a life insurance policy can trigger tax on the entire gain (including loan satisfaction), not just the cash received. Before surrendering a policy, policyholders must carefully calculate their "investment in the contract" (basis) and compare it to the total gross distribution (cash received plus the amount of the loan satisfied). This calculation will determine the taxable amount. Taxpayers need to remember that the lack of physical receipt of cash is irrelevant when a loan is satisfied upon surrender; the IRS will treat it as if cash changed hands.