Loans Against Life Insurance Failure to Make Premium Payments May Result in Tax Liability

Life insurance policies are held by many American taxpayers. While valuable, policies are generally illiquid, making them a candidate to use as collateral to borrow against.  As illustrated in a recent United States Tax Court summary opinion[1], failure to make the requisite premium payments on the life insurance policy used to secure a loan may result in a tax liability should the insurance provider use the cash value of the policy to make the loan payments.


Prior to 2017, the taxpayer obtained multiple loans, using the cash value of two separate life insurance policies as collateral. In 2017, the taxpayer was incarcerated, after which he ceased making premium payments on the two policies. Both policies subsequently lapsed, and the life insurance carrier notified the taxpayer that his nonpayment resulted in terminations of both the loans and underlying policies. The life insurance carrier then used the cash values of both policies to satisfy the outstanding principal and interest of the loans. The life insurance carrier then issued the taxpayer a Form 1099-R[2] for 2017 for each respective policy and reported taxable distributions from life insurance to the IRS.

The amounts reported on the two Forms 1099-R were calculated as the outstanding loan amount paid by the cash value of the policy, less the total premiums paid by the taxpayer. The taxpayer failed to file a 2017 federal income tax return. In March of 2020, the IRS prepared a substitute for return (“SFR”) for the taxpayer’s 2017 tax year[3] and shortly thereafter issued a notice of deficiency for the 2017 tax year, including in the taxpayer’s gross income the taxable distributions reported by the life insurance carrier.

The primary issue for decision before the Court was whether the taxpayer received constructive distributions of income, as reported on the Forms 1099-R, from the two life insurance policies. The taxpayer, representing himself, conceded that he was the holder of such policies, that the policies lapsed in 2017, and that he had no dispute regarding the computation of the amounts reported on the Forms 1099-R. The taxpayer argued that the termination of both the loans and life insurance policies should not result in income for the year in question because he did not actually receive any cash when the policies were terminated.


Income from life insurance contracts constitute gross income.[4] Other than death benefits or annuities, distributions from life insurance contracts are included in gross income to the extent they exceed the amount invested in the contract.[5] The amount invested in the contract is the amount of total premiums less any distributions previously received as income but excluded from gross income calculations.[6]

Even if a taxpayer does not receive cash from a life insurance policy during a tax year, the taxpayer can still be deemed to receive a constructive distribution from the termination of the life insurance policy which must be included in the taxpayer’s gross income.[7] The lapsing of a life insurance policy, along with a termination of indebtedness collateralized by the policy, functions as if the cash value of the policy is applied against the outstanding debt,[8] and the application of the cash value against the debt is no different than if the life insurance carrier had distributed the proceeds directly to the taxpayer to use to pay off the outstanding debt.[9]


The Court found that when the life insurance policies lapsed, and the cash values were used to repay the outstanding debt, the taxpayer constructively received the cash values of the policies. The amounts used to repay the outstanding debt which were in excess of the taxpayer’s investment in the contracts were therefore includible in the taxpayer’s gross income.

The Court also, to little surprise, rejected the taxpayer’s argument that he should not recognize income because he did not receive any cash, finding that it was “irrelevant that no money changed hands,”[10] and that as the physical receipt of cash does not dictate taxability, the lack of distribution of cash to the taxpayer has no effect on the tax liability resulting from the constructive receipt. Ultimately, the Court found that the taxpayer had received and failed to report life insurance income from the two lapsed policies reported on the Forms 1099-R.


This case has no novelty, and I doubt the Court found it difficult to reach its ultimate decision. The taxpayer presented no viable argument as to why the Court should decide in his favor. Still, simple cases like this do serve as important reminders to those in similar positions. Life insurance policies are widely held, and many borrow against their policy. Should you borrow against your policy and let your policy lapse, whether intentionally or not, you should expect a tax liability if your life insurance carrier pays off such debt.

[1] Doggart v. Comm’r, T.C. Summ. Op. 2023-25 (2023).

[2] Form 1099-R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

[3] I.R.C. § 6020(b).

[4] I.R.C. § 61(a)(9).

[5] I.R.C. § 72(b).

[6] I.R.C. § 72(e)(6).

[7] Black v. Comm’r, T.C. Memo 2014-27.

[8] McGowen v. Comm’r, T.C. Memo 2009-285.

[9] Feder v. Comm’r, T.C. Memo 2012-10.

[10] Brown v. Comm’r, 693 F.3d at 768.

Parker Durham, J.D., LL.M.

Parker practices in the areas of business, tax, and estate planning. Parker recently graduated with his Master of Laws in Taxation from the University of Florida Levin College of Law, and he is currently satisfying the requirements necessary to obtain his Certified Public Accountant license. View Full Profile.


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