Taxable Gain - Surrender of Life Insurance Policy

[Forensicacctnt]

Life insurance policy (a mutual life ins. co.) was cashed out in 2017. Taxpayer received a 1099-R listing a taxable amount of about $12,000, gross cash value was about $14,000 and cost basis, $2,000. Cost basis was difference in total premiums $10,000(paid by parents of taxpayer) and total dividends, $8,000. The taxpayer cashed out the policy in 2017 for financial needs, receiving about $4,000 ( $14,000 cash value less loan debt, $10,000). A letter from the life insurance company explained the taxable gain as the gross cash value less cost basis referring to IRC Section 72. Is the taxable gain correct? Thank you!

[ATSMAN]

If the figures that you state are accurate, then the cost basis should be the sum of premiums paid less dividends received (also considered a refund of premiums paid in prior years). For life insurance policies issued by mutual life companies that pay dividends, people tend to ignore that in the basis calculation. If the policy (stock life company) did not pay dividends then that would not be an issue. The outstanding loan and any other charges are simply deducted from the proceeds and don't factor into the taxable gain calculation. So it appears correct IMHO.

[Forensicacctnt]

Thank you for the response and help on this matter.
Carl

[ATSMAN]

Here you go: https://www.irs.gov/irb/2009-21_IRB#RR-2009-13

[Burke]

. The outstanding loan and any other charges are simply deducted from the proceeds and don't factor into the taxable gain calculation. So it appears correct IMHO.

The outstanding loan WAS factored into the taxable gain calculation. Note it was deducted from the cash surrender proceeds as it had been received at a prior time. (It was not taxable income until such time as the policy was cashed in without the loan being paid back.) It then became a deemed distribution under the IRC rules. The net taxable amount received at termination is reported on Form 1099R and includes the prior loan in the calculation. This treatment was put into place back in the 80's as I seem to recall, when people were trying to use life insurance policies as tax shelters. So given the facts as you have related them, it appears to be correct.

[ATSMAN]

The outstanding loan WAS factored into the taxable gain calculation. Note it was deducted from the cash surrender proceeds as it had been received at a prior time. (It was not taxable income until such time as the policy was cashed in without the loan being paid back.) It then became a deemed distribution under the IRC rules. The net taxable amount received at termination is reported on Form 1099R and includes the prior loan in the calculation. This treatment was put into place back in the 80's as I seem to recall, when people were trying to use life insurance policies as tax shelters. So given the facts as you have related them, it appears to be correct.

What I meant was that you don't deduct the loan balance again. It was already accounted when calculating basis. Perhaps I should have been clear.