A recent 10 U.S. Circuit Court of Appeals considered whether taxpayers could avoid a $171,631 tax bill after their life insurance policy was terminated by the carrier [McGowen v. Commissioner, No. 10-9000 (2011)].
As we've seen before, if a policy is terminated and a policy loan forgiven, the insured will be on the hook for the amount of debt that is cancelled. What's unique about this case is the McGowens' argument that they did not owe tax on the debt forgiveness because they were insolvent at the time the debt was forgiven.
Income from a discharge of indebtedness is generally taxed. Cash received from a loan is not taxed—the borrower will have to pay back the loan, so it isn't income to the borrower. But if the loan is forgiven and the borrower is no longer required to repay, the borrower has received income.
The general principle that a forgiveness of debt equals income is applicable where a taxpayer's life insurance policy is terminated when a policy loan is outstanding.
There are exceptions to the rule that a forgiveness of debt is includable in a taxpayer's gross income. Under Section 108 of the Tax Code, a forgiveness of debt is not includable in a taxpayer's gross income to the extent the taxpayer is insolvent immediately before the loan is forgiven. For example, if taxpayer in the first example has a net worth of $50 at the time a $100 debt is forgiven, half the $100 debt cancellation is includable in the taxpayer's gross income. The other $50 of debt forgiveness can be excluded from the taxpayer's gross income under the insolvency exception.
In the case, Mrs. McGowen purchased a life insurance policy on her life for a single $500,000 premium payment. The McGowens took significant loans on the policy, and when the loan balance of $1,064,784.86 surpassed the cash value of the policy, the carrier informed Mrs. McGowen that the policy would be canceled if she didn't pay $108,313.42 to keep the policy active. She did not make the payment and the policy was terminated.
The McGowens acknowledged on their income tax return that they received income from a cancellation of debt. But the McGowens argued that, like the taxpayer in the example above, they were insolvent when their aggregate assets were offset by their aggregate liabilities, including the policy loan.
