Taxable Income From Upside-down Insurance Policies

Michael and Kathyrn were married. Each hada benefit plan that permitted them to purchase with a single premium a variablelife insurance policy with a three-year lapse free guarantee. Before the three-yearterm the benefit, plan requirements terminating the policies. Both policieswere penalized for cancellation at the time of the distribution. The penalty amountexceeded the policy value. As a result, neither policy paid out any money.Because neither policy paid out neither believed they had to report any taxableincome from the distribution on their income tax. The government issued an$81,000 deficiency unreduced by the penalties. 

In Schwab v. Commissioner, the court determinedthat the value of the policies were the same as the remaining value of the lifeinsurance coverage until the lapse occurred and thus the policies should betaxed. The court held further that the policies fair market value is recognizedtaxable income. Additionally, penalties can change the fair market value.However, there is no standard measure of a life insurance policy’s fairmarket value.

See Kathy Sherby That Underwater Policy Does Not Have Any Value, Right?, Trust Bryan Cave,  Jul. 30, 2013.