Taxes due on lapsed Life Insurance policy

[jmcdtax]

Client's grandmother took out apparently a whole life insurance policy several years ago when the client was an infant. At some point someone borrowed $40,000 against the policy and never paid it back. Now the client has received notice that the policy has lapsed and that she owes taxes on the $40,000 loan plus the interest/dividends accrued before the policy lapsed. Client never knew any thing about the policy or the loan until she received notice of taxes due. I don't have all the details and I have not seen the notice yet. Will meet with her tomorrow. Anyone know of any relief that maybe applied for in such a situation.

[spanel]

Assuming Grandma is over 59 1/2, she will taxes based off $40,000 (1099R). Guessing notice was from IRS? The Insurance co never contacted her?!?! Maybe someone else got a $40,000+ loan against it and stopped paying the payments? Might be a legal problem also. (Also sometime older ppl do things they dont remember as well)

Chris

[Burke]

The unpaid loan is considered as a deemed distribution. Has she actually received a 1099-R or just a letter from the insurance company? Usually, the cash value (or deemed distribution loan amount) is only taxed to the extent it is in excess of premiums paid into the contract less dividends & interest. It may not all be taxable. IRS changed this many years back to keep policyholders from hiding tax free money inside insurance policies. She needs to contact the insurance company for a complete breakdown as to how this was calculated, and when this loan was made and to whom and what the exact taxable amount is. They have all this information. Grandma would have been the owner originally, and it probably passed to client when she turned 18 or 21. Is Grandma still living? $40K is an extremely large amount of cash value (not death benefit) for a standard cut-and-dried life whole life insurance policy unless it had a variable feature, was invested in the stock market and accumulated a lot of capital gains. Unfortunately, capital gains rates will not apply to this situation. When you review the "notice" advise what it says. Curious.

[jmcdtax]

Thank you both for your responses.After meeting with her, she has not received any notice (1099-R) from the IRS. The insurance company is hounding her to pay off the loan plus interest, which she assumes was taken out by her grandmother to bail out the client's father when the client was a minor. The client signed nothing and knew nothing about the loan. The grandmother passed away several years ago. And the client has very little contact with the father. They became estranged during her childhood. The insurance company will not provide her with any detailed info and she refuses to pay off the loan. I suggested she contact an attorney.

[Dude]

How it normally works: A loan on whole life usually does not exceed premiums paid. If said loan is unpaid the benefit is reduced proportionately. If premiums also cease the loan is canceled usually resulting in a 1099 R being issued for the amount of growth over basis. Unless Grandma paid $40,000 in premiums it sounds like she negotiated some pretty good loan terms back in the day. I wonder if this is the reason the insurance company is so insistent about repayment.

Considering most Life policies see little growth due to incessant fees, it is hard to have sympathy for the collector, even more so since they resorted to collection techniques.

What the company should do: Issue a 1099 R for the gain unless the beneficiary wants to reinstate the policy. If they do allow them to reinstate the policy with the understanding the benefit will be MINUS $40,000.

Or they could step up collection efforts and forever be deemed "slime" by the granddaughter AND EVERYONE SHE EVER TALKS TO.

[Burke]

I doubt the insurance company is "hounding" her to pay off this loan. Of course, they are trying to reinstate the policy and have her pay the loan off, but they have no legal recourse to force her to do anything. They are more than likely giving her notice that she may have a taxable situation if the loan is not repaid. NOTE: A life insurance policy is a unilateral contract meaning only the insurance company has any obligation -- and that is to pay benefits to the insured -- if they are due. The policyholder has no contractual obligations to pay premiums and/or repay a previous loan and cannot be forced to do so. The policy simply lapses if the premiums are not paid, and no benefits are due after that. If a loan was taken out it would have been secured by its underlying cash value which is a non-forfeiture benefit. In other words, it is guaranteed by the contract's cash value which is vested in the owner of the policy and cannot be forfeited. If premiums are discontinued, the policy's death benefit would still continue and provide coverage as long as there were sufficient cash values to continue the insurance. After a while, any loan interest (if not paid) would eat up the cash value since it adds to the outstanding loan. This is apparently what has happened, and the policy has lapsed. Review the correspondence and advise what it says exactly. They cannot threaten anything if indeed this is a policy loan and not something else. That does not mean that a previous distribution might not be partially taxable under IRS regulations, if it is not reinstated and premium payments resumed.