Barr v. Commissioner of Internal Revenue, T.C. Memo. 2009-250 (U.S.T.C. 11/3/2009), 8705-08.
| Decision Date | 03 November 2009 |
| Docket Number | No. 8705-08.,8705-08. |
| Parties | HARVEY S. AND WILLYCE BARR, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | United States Tax Court |
Harvey S. Barr, for petitioners.
Steven N. Balahtsis, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined a $39,608 deficiency in petitioners' 2005 Federal income tax and a $7,922 accuracy-related penalty under section 6662(a).1 After a concession by petitioners,2 the issues for decision are: (1) Whether petitioners recognize ordinary income or capital gain from the surrender of a life insurance policy; and (2) whether petitioners are liable for the section 6662(a) penalty. We hold that petitioners' gain is ordinary income. We hold further that petitioners are liable for the accuracy-related penalty.
Some of the facts have been stipulated and are so found. The first stipulation of facts, the second stipulation of facts, and the attached exhibits are incorporated herein by this reference. Petitioners resided in New York at the time they filed their petition.
Harvey S. Barr (petitioner) has been an attorney since 1964 and currently is a partner at the law firm Barr, Post & Associates PLLC. Petitioner specializes in complex commercial transactions and bankruptcy law and is admitted to practice before the U.S. Tax Court, several U.S. District Courts, the U.S. Court of Appeals for the Second Circuit, and the Supreme Court of the United States. Willyce Barr is petitioner's wife.
Petitioner's mother, Lillian Barr (Ms. Barr), is a retired schoolteacher and currently resides in New York. She taught in Arizona, where she lived from the mid-1960s until 2006.
In 1980 Ms. Barr wanted to purchase a life insurance policy to help her children pay the anticipated estate tax liability after her passing. Petitioner convinced Ms. Barr to meet and discuss the issue with Jack Tilden of New England Mutual Life Insurance Co. in New York (New England Mutual), with whom petitioner shared office space. Ms. Barr agreed, and she and petitioner met with Mr. Tilden.
On December 13, 1980, New England Mutual issued a life insurance policy (the policy) insuring the life of Ms. Barr. The policy was a whole life policy with a face amount of $200,000. It was not an annuity. Petitioner and his sister, Susan Roe (Ms. Roe), were coowners and beneficiaries of the policy. Under the terms of the policy all communications including premium notices were sent to petitioner's Spring Valley, New York, address.
The annual premium due under the policy was $8,929. For the first 8 or 9 years Ms. Barr indirectly paid the premiums by gifting half of the amount to petitioner and half to Ms. Roe. Petitioner and Ms. Roe then paid the premiums directly. No additional payments were made by petitioner, Ms. Roe, or Ms. Barr after the first 8 or 9 years. Thereafter, the policy borrowed against itself to pay the premiums; i.e., premiums were automatically paid from dividend accumulations and loans against the cash value of the policy (policy loans). Other than automatic policy loans used to pay the premiums, no one ever borrowed against the policy.
By 2005 the policy was held by New England Financial, a Metropolitan Life Insurance Co. (MetLife) affiliate. On July 25, 2005, New England Financial sent a letter to petitioner explaining the tax consequences of the policy along with a statement of gain. The letter stated in pertinent part:
According to federal tax law, a policy contains taxable gain to the extent that its cash value (including loaned cash value) exceeds its Total Net Investment.
Generally, gain must be recognized as taxable income to the extent any cash received or loan extinguished exceeds Total Net Investment. * * * We are required to report any taxable income to the Internal Revenue Service on Form 1099-R.
You may wish to consult with your tax advisor if you have any doubt concerning the tax treatment of this contract.
New England Financial provided a second statement of gain to petitioners dated September 13, 2005. According to the statement of gain, the net investment in the policy at the time was $225,390.14, the total cash value was $361,353.58, the total indebtedness was $354,399.25, and the taxable gain was $135,963.44.
On October 10, 2005, New England Financial sent a letter to petitioner notifying him that the policy was in overloan.3 In order to continue the policy in force petitioner was required to pay both the overloan amount, $1,541, and the premiums due at the time, $2,286.38. The letter included the following language: "Should you allow the Policy to terminate through failure to pay the overloan amount, New England Financial is required by Federal law to report any taxable gain to the Internal Revenue Service."
Petitioner reviewed one or more of the letters received from New England Financial in 2005 and discussed their contents with Ms. Barr. They decided the policy was no longer necessary and allowed it to terminate. Petitioner surrendered the policy effective December 20, 2005. He was the sole owner and beneficiary at the time.4
In 2005 petitioner received and cashed a check from MetLife for $11,648.33 as well as a check for a $304.20 dividend. In January 2006 petitioner received a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., from MetLife showing a gross distribution and taxable amount of $135,963.44 for 2005. Petitioner also received a Form 1099-DIV showing a $304.20 taxable dividend from the surrender of the policy.
Petitioners timely filed their joint Federal income tax return for 2005. Petitioners did not include either the $135,963.44 shown on Form 1099-R or the $304.20 shown on Form 1099-DIV in their gross income reported on their return.5
OPINIONGross income includes all income from whatever source derived, including income from life insurance contracts. Sec. 61(a)(10). Any amount received upon the surrender of a life insurance contract which is not received as an annuity is specifically included in gross income to the extent that it, when added to amounts previously received under the contract and excluded from gross income, exceeds the investment in the contract.6 Sec. 72(e)(5)(A), (C); sec. 1.72-11(d)(1), Income Tax Regs.
When the policy terminated, petitioner received a net distribution of $11,648.33. This amount represents the total cash value, $361,353.58, plus a terminal dividend, $4,694, less $354,399.25 which was withheld to repay the outstanding policy loan balance. The satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to petitioner and constituted income to him at that time. See Atwood v. Commissioner, T.C. Memo. 1999-61. Thus, petitioner constructively received the policy's cash value of $361,353.58 without reduction for outstanding loans upon surrender. Petitioner's net investment at the time of surrender was $225,390.14. Accordingly, despite receiving a check for only $11,648.33, petitioner is taxable under section 72(e) on the $135,963.44 gross distribution MetLife reported to the IRS on Form 1099-R. See id.; cf. Dean v. Commissioner, T.C. Memo. 1993-226 ().
To recognize a capital gain or loss, petitioner must have engaged in a "sale or exchange" of a capital asset. Sec. 1222(1) through (4); Nahey v. Commissioner, 111 T.C. 256, 262 (1998) affd. 196 F.3d 866 (7th Cir. 1999). Though the Code does not define what is a sale or exchange, the terms "sale" and "exchange" are given their ordinary meaning. Helvering v William Flaccus Oak Leather Co., 313 U.S. 247, 249 (1941). Generally, the lapse, cancellation, surrender, or termination of a contract does not equate to a sale or exchange.7 Wolff v. Commissioner, 148 F.3d 186, 190 (2d Cir. 1998), revg. Estate of Israel v. Commissioner, 108 T.C. 208 (1997).
The surrender of an insurance policy is not a "sale or exchange" of a capital asset and thus does not result in capital gain. See Hellman v. Commissioner, 33 B.T.A. 901, 902 (1936) (); see also Perkins v. Commissioner, 41 B.T.A. 1225, 1228-1229 (1940), affd. 125 F.2d 150 (6th Cir. 1942); Chapin v. McGowan, 271 F.2d 856, 858 (2d Cir. 1959); Blum v. Higgins, 150 F.2d 471, 474 (2d Cir. 1945); First Natl. Bank of Kansas City v. Commissioner, 309 F.2d 587, 589 (8th Cir. 1962), affg. Estate of Katz v. Commissioner, T.C. Memo. 1961-270; Gallun v. Commissioner, 327 F.2d 809 (7th Cir. 1964), affg. T.C. Memo. 1963-167; Avery v. Commissioner, 111 F.2d 19, 23 (9th Cir. 1940); Bodine v. Commissioner, 103 F.2d 982, 987 (3d Cir. 1939) ().
Petitioners acknowledge the legal precedent; i.e., gain recognized from the surrender of a life insurance policy receives ordinary income treatment. Nevertheless, petitioners argue that the facts here are so exceptional as to require capital gain treatment. To support this position, petitioner cites Commissioner v. Phillips, 275 F.2d 33, 36 n.3 (4th Cir. 1960), revg. 30 T.C. 866 (1958), which states:
On reargument, counsel for the Commissioner conceded that there may be exceptional circumstances requiring a modification of this rule [ordinary income treatment]. For example, if a policyholder had an amount receivable thereunder which was in excess of his cost, but policyholder was afflicted with a disease which would result in his death in the near future, he could, if in need of cash, assign his policy for an amount in excess of that receivable under the policy and, as to such excess, treat the same as...
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