Sidestepping Income Tax When a Policy with Outstanding Loans Is CancelledPosted September 19th, 2011
A recent Tenth Circuit Court of Appeals case 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 have 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 is 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 is not income to the borrower. But if the loan is forgiven and the borrower is no longer required to repay, the borrower has received income.
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For previous coverage of the income taxation of policy loans in Advisor’s Journal, see When Are Policy Loans Taxable? (CC 11-122).