Make sure that policy is really "Cashed In"

Life insurance and taxes can be a mind-numbing and confusing combination for most people.

Normally, the death benefit received from a life insurance policy is not considered taxable income.

However, income can be taxable when you cash in the policy during your lifetime to receive the cash surrender value. In that case, the difference between the cash value of the policy and your investment in the contract - which is generally the total premiums you have paid - is considered taxable income.

A recent Tax Court decision deals with the unusual case of Yulia Feder (Yulia Feder v. Commissioner, TC Memo 2012-10, Jan. 10, 2012).

In 1983, Yulia purchased a life insurance policy with a $50,000 death benefit. From 1983 through 1987, she paid the quarterly premiums as they became due. On Jan. 3, 1988, Yulia sent a letter to the insurance company requesting that her policy be canceled immediately and that future communications be sent to her new address.

For some reason, the insurance company either did not receive Yulia's letter or lost it. In any event, the policy Yulia thought she had canceled remained in force.

Using the automatic loan feature contained in the policy, the insurance company caused Yulia to borrow the necessary premium against the cash value of the policy from 1987 to 2007. It used the loan proceeds to pay the premiums as they became due.

By mid-2007, when the premium became due, the amount of the loan equaled the cash value of the policy. Since the insurance company could no longer lend Yulia the amount necessary to pay the premium, the policy lapsed. At that time, the loan against the cash value of the policy totaled $12,654.

Upon lapse, the insurance company used the policy's cash value to pay off the loan of the same amount. After deducting total premiums paid of $7,029 from the loan amount, the insurance company arrived at a taxable distribution of $5,625.

The Tax Court agreed with the IRS that Yulia owed tax on the $5,625, even though she received no actual cash distribution from the insurance company.

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