In Estate of Feder, Yulia Feder learned the hard way that failure to properly cancel a life insurance policy can lead to income tax consequences.
In a recent Tax Court decision, Estate of Feder, T.C. No. 1628-10, T.C. Memo. 2012-10, January 10, 2012, the Tax Court had no trouble ruling that the taxpayer, Yulia Feder, received taxable income on the lapse of her old Northwestern Mutual life insurance policy even though she did not receive any cash from the policy at that time.
In this case, Feder had paid $73 per quarter in premiums on her $50,000 life insurance policy until November of 1987. In January of 1988, Feder purportedly wrote a letter to Northwestern Mutual requesting that her policy be cancelled, and providing a new address to which all future correspondence should be sent. Feder testified that she had not received any further correspondence from Northwestern Mutual after making that request and thought the policy had been cancelled. However, Northwestern Mutual’s records show that Feder had made two more quarterly premium payments after that date, later in 1988 and early 1989. After that time, she simply forgot about the policy. Policy premiums were then paid using loans of the policy’s cash value.
In 2007, the loan against the policy for the payment of the quarterly premiums equaled the cash value, and the policy lapsed. The cash value was then used to pay the policy loan and in 2008, Northwestern Mutual issued a 1099-R to Feder for the taxable distribution from the policy in the amount that the cash value used to pay the policy loan exceeded the amount of the premiums paid ($5,625). However, the 1099-R was sent to Feder’s old address, so that Feder had never actually received the 1099-R. In 2009, Feder learned of the additional unreported income for 2007 from the IRS. Feder contacted Northwestern Mutual and learned that her policy had not been cancelled, that she had not filed the proper paperwork to do so, and that the policy had lapsed in 2007 producing the taxable income. Feder then proceeded to represent herself in the tax case, until the trial.
At trial, the government introduced Northwestern Mutual’s records as to the premium loan history and the correspondence with Feder, which the court held was sufficient to link Feder to the “tax generating activity” reflected on the 1099-R. Feder did not present any evidence that she cancelled the policy in accordance with the terms of the policy and she did not introduce the policy as evidence.
The court held that the use of the cash value on the policy to pay off the policy loan was “the economic equivalent of Northwestern’s distributing to petitioner $12,654 and her using that amount to pay off the policy loan.” This constructive distribution was taxable income to Feder at the time the policy lapsed. This taxable income produced a tax assessment of $1,713.
You might ask why all this fuss over that amount of additional tax! And NO, the Lawrence M. Brody listed among those attorneys for the petitioner in the trial of this case is not the Lawrence Brody that most associate with life insurance taxation expertise (and who is a contributor to this blog).