Individual Didn't Receive Taxable Deemed Distribution from Insurance Policy Termination

Mark J. Tober, for respondent.

Respondent determined a $2,768² deficiency in petitioner's Federal income tax for 2008. The issue for decision is whether petitioner received a taxable deemed distribution in 2008 upon the expiration of his life insurance policy. For the reasons stated herein, we hold that petitioner did not receive a taxable deemed distribution in 2008 and therefore is not liable for the $2,768 deficiency.

A. Nationwide's Record of Premium Payments

The following schedule reflects Nationwide's record of petitioner's premium payments (premium record):

    Due Date        Received Date     Transaction Amount    Payment Frequency

B. Nationwide's Record of Loan Payments

Nationwide's record of automatic loan payments (loan record) coincides with the information in the premium record⁷ - Nationwide issued its first automatic premium loan to petitioner on January 9, 1981, and continued issuing automatic premium loans annually through 2007.

C. Correspondence Between Nationwide and Petitioner

As mentioned supra, petitioner resided in Virginia at the time he entered into the life insurance contract with Nationwide. At that time, he was in the military. For the past 12 years, petitioner has lived at the same address in Florida. He received mail from Nationwide at that address but generally believed that this mail was marketing materials. Nationwide provided copies of letters sent to petitioner on the following dates at his Florida address:

1. November 27, 2005 -- Nationwide sent petitioner a letter informing him that "[s]ince we have not received payment for your past due premium, and, there was sufficient cash value on your policy, the premium has been paid by the Automatic Premium Loan Provision." The letter also stated that: (1) the premium due date was September 28, 2005; (2) the loan amount used to pay the premium was $291;⁸ and (3) the total loan on the policy was $18,722.⁹

2. November 27, 2006 -- The following year Nationwide sent petitioner a letter informing him that because Nationwide had not received his past due premium on his life insurance policy "the automatic premium loan provision has jumped in to help". The letter stated that the loan amount used to pay the premium was $291¹⁰ and the total loan on the policy was $20,154.

3. December 8, 2006 -- This letter informed petitioner that his current surrender value in the policy was $856. Moreover, the letter stated that Nationwide was aware of petitioner's request to terminate his policy and enclosed a pamphlet to help him decide whether that decision was really best for him.¹¹ Finally, the letter stated that petitioner would have to complete a "surrender application" to officially terminate the policy.¹²

4. November 27, 2007 -- The next year Nationwide sent another letter to petitioner informing him that once again "the automatic premium loan provision has jumped in to help". The letter stated that the loan amount used to pay the premium was $291¹³ and the total loan on the policy was $21,671.

5. November 30, 2008 -- One year later, Nationwide sent petitioner a letter informing him that he was in default and therefore the policy had been converted to extended term insurance effective September 28, 2008.¹⁴ Moreover, the letter stated that because the policy had been converted, the automatic premium loans were now permanent withdrawals resulting in taxable income of $17,941 for the 2008 tax year.

6. August 5, 2009 -- This letter informed petitioner of the requirements to reinstate his policy: (1) complete and return the reinstatement application; and (2) upon approval of the reinstatement application, make a premium payment of $581 and a loan payment of $1,255.

7. February 21, 2010 -- This letter informed petitioner that his extended term insurance had expired without value.

D. Nationwide's Calculation of Petitioner's 2008 Constructive Distribution

Nationwide sent a letter to respondent dated March 14, 2012, explaining how Nationwide had determined petitioner's 2008 taxable distribution. The letter explained that petitioner's premiums were due on the "anniversary of the policy" and that when premiums were not paid, the automatic premium loan provision was used to pay the premiums. The letter went on to explain that the automatic premium loan provision continued to pay the premium until the policy value could no longer continue supporting additional loan amounts, which occurred in 2008.¹⁵ Finally, the letter provided the following calculation of petitioner's taxable gain:

      Cash Value                                               Amount

The factual issue in this case is whether the life insurance policy expired during the 2008 tax year. Petitioner argues that the policy expired around the time when he ceased making premium payments, by the very terms in the contract. He introduced the life insurance policy contract and credibly testified as to his understanding of how the reinstatement, automatic premium loan, and nonforfeiture provisions interacted. Furthermore, petitioner has cooperated with the Internal Revenue Service. We find that petitioner has produced credible evidence that the policy should have terminated before the 2008 tax year, and thus the burden of proof shifts to respondent.

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. See Minnis v. Commissioner, 71 T.C. 1049, 1054 (1979); Sanders v. Commissioner, T.C. Memo. 2010-279; Atwood v. Commissioner, T.C. Memo. 1999-61. Thus, using the policy's proceeds to satisfy the loans has the same effect as paying the proceeds directly to the policyholder. See e.g., Atwood v. Commissioner, T.C. Memo. 1999-61. In V.R. Deangelis M.D.P.C. v. Commissioner, T.C. Memo. 2007-360, aff'd, 574 F.3d 789 (2d Cir. 2009), we explained the significance of automatic premium loan provisions --

The policy contract provides: (1) premium payments not paid on or before their due date "will be in default"; (2) after default, the policy will remain in effect for a 31-day grace period; and (3) the policy will terminate if premiums are unpaid by the end of the grace period. Furthermore, the policy contract goes on to explain that: (1) the policy may be reinstated within five years after the due date of the premium payment first in default upon Nationwide's receipt of certain evidence from petitioner; (2) an automatic premium loan will automatically be granted to pay a premium in default when the policy has a net cash value; and (3) the policy will automatically be placed on extended term insurance if no payment is made by the end of the 31-day grace period.

Several of the premium payments were made after the expiration of the grace period -- the payments were not made in time to prevent the insurance policy from terminating. Premium payments due October 28, November 28, and December 28, 1975, January 28, 1976, and March 28, 1977, were not made within the grace period, and Nationwide did not issue automatic premium loans to prevent the policy from terminating.¹⁸ Accordingly, the policy should have terminated and been converted to extended term insurance following the expiration of the grace period for any of the aforementioned due dates.

Moreover, all premium payments due beginning September 28, 1980 through 2007, were not made within the grace period. Automatic premium loans were issued to pay the premiums three months after their respective due dates. The automatic premium loan provision functions to pay premiums in default. If a premium was not paid by the end of the grace period, the policy terminated. After termination the policy had to be reinstated by certain affirmative actions by petitioner -- the automatic premium loan provision could not reinstate the policy after it had terminated.

The policy contract provided that the frequency of premium payments could be altered only by a written request to Nationwide; however, there is no evidence in the record that such request was made. Accordingly, by the very terms of the contract, the policy should have terminated at the expiration of the grace period for any of the aforementioned premium payment due dates. Respondent has failed to explain why the policy continued to remain in effect when by the very terms of the contract it should have terminated on several occasions.

We are not persuaded that petitioner's life insurance policy terminated in 2008 resulting in a taxable deemed distribution. Respondent's argument would have us construct a multitude of inferences in his favor and simultaneously turn a blind eye to several unexplained discrepancies in the record. This we will not do. We believe a plain reading of the terms in the life insurance contract signifies that the policy should have terminated and been converted to extended term insurance on several occasions before 2008.

Decision will be entered for petitioner.

² All amounts are rounded to the nearest dollar.

³ Premium payments for whole life insurance are bifurcated so that part of each payment is attributed to the cost of insurance and part accumulates as cash value. The insurer invests the cash value, which continues to grow tax deferred as long as the policy is in force. The insured can borrow against the cash value, but unpaid policy loans and interest will be subtracted from the death benefit.

⁴ The extended term insurance option allows the policyholder "[t]o continue this policy as nonparticipating extended term insurance from the due date of the premium in default for an amount equal to the face amount, plus the face amount of any paid-up additions and the amount of any dividend accumulations and less any indebtedness to the Company on this policy."

The period of extended term insurance "shall be such as the net cash value will provide when applied as a net single premium at the attained age of the Insured on the date the premium is in default."

⁵ Petitioner's policy was in a standard premium class.

⁶ Respondent alleged in his pretrial memorandum that petitioner stopped making payments after the September 28, 1979, payment. However, at trial respondent seemed to agree that petitioner ceased making payments after the February 28, 1977, payment.

⁷ The "APL" reference in the premium record indicates that the payment was made through an automatic premium loan. The loan record shows automatic premium loan payments issued on the same dates as in the premium record.

⁸ The loan was not issued until December 23, 2005.

⁹ Aside from petitioner's election of the automatic premium loan provision in the 1975 life insurance contract, the November 27, 2005, letter is the earliest record supporting that petitioner received notice that the automatic premium loan provision was being implemented to pay the outstanding premium on his policy.

¹⁰ The loan was not issued until December 28, 2006.

¹¹ On the contrary, as noted supra, petitioner testified that he did not attempt to cancel his policy. It is unclear from the record whether petitioner requested to terminate the policy in 2006.

¹² There is no evidence in the record indicating that petitioner completed the surrender application.

¹³ The loan was not issued until December 23, 2007.

¹⁴ At that time the cash available in the policy was $253, which was used to purchase extended term insurance that would expire March 23, 2010.

¹⁵ It is unclear from the record how the automatic premium loans affected the policy value and how the policy value continued to support the issuance of the automatic premium loans for approximately 30 years when petitioner made premium payments totaling only $472.

¹⁶ The sum of premium payments in the premium record is $9,828.

¹⁷ While we recognize that sec. 6201(d) may shift the burden of production to respondent, because respondent has met this burden, we do not address the issue further.

¹⁸ It is unclear why Nationwide did not issue automatic premium loans to pay these premiums.