When Are Insurance Policy Loans Taxable?

In 2005 Todd filed his delinquent 2002 and 2003 tax returns, and the IRS found deficiencies on Todd's return, although it was not made immediately aware of the payment from the fund to Todd. But in preparation for trial on those issues, the IRS discovered the $400,000 payment.

The IRS claimed that the $400,000 distribution from the fund was taxable when received because it was not a valid loan. The IRS also argued that even if the payment was a valid loan, the debt was discharged in 2003 and Todd should have reported discharge of indebtedness income. Penalties were assessed against Todd.

The Tax Court's Reasoning

The Tax Court considered whether the $400,000 payment to Todd was a loan for income tax purposes. According to the court, "a distinguishing characteristic of a loan is the intention of the parties that the money advanced be repaid."

The court listed seven factors it considers when determining whether a loan is a bona fide loan and whether the parties intended to form a creditor-debtor relationship, as follows: (1) whether the loan is evidenced by a note; (2) whether interest is charged; (3) whether there is a schedule of payments; (4) whether payment of the loan was secured by collateral; (5) whether payments were actually made on the loan; (6) whether "the borrower had a reasonable prospect of repaying the loan, and whether the lender had sufficient funds to advance the loan"; and (7) whether the parties acted as if the payment was a loan.

In this case, the first four hallmarks of a loan that are listed above were at least arguably present; there was a note, 1% interest was charged, an amortization schedule was produced, and payment of the loan was secured by any future obligations of the fund to Todd and his beneficiaries.

The court, however, disregarded most of these factors. The promissory note was disregarded because it was not produced at the time the $400,000 payment was made. And although the fund document required a reasonable rate of interest to be charged on any loans made to participants, the 1% interest rate was less than a quarter of what the fund charged on a similar loan—4.76%. Finally, although a payment schedule was produced, payments were never made according to the schedule.

The Tax Court found that only two of the seven factors listed above tended to indicate that the parties intended to form a bona fide debtor-creditor relationship. The dual-repayment mechanism by which repayment of the loan was secured by future benefits tended to show that a debtor-creditor relationship existed. Also, Todd had a reasonable prospect of repaying the loan – another indicator that the loan was bona fide. But after weighing the above factors, the court found that there was little evidence that a debtor-creditor relationship existed between Todd and the fund.

Based on its weighing of the seven factors, the court held that the distribution from the fund was immediately taxable to Todd at the time it was made. The court also found that Todd was liable for accuracy-related penalties.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne's partner, AdvisorFX, for a free trial.

See also The Law Professor's blog at AdvisorFYI.