A Dangerous Thing

In Uncategorized on 04/13/2011 at 17:04

Or, As Alexander Pope Put It

A little learning is a dangerous thing;
Drink deep, or taste not the Pierian spring:
There shallow draughts intoxicate the brain,
And drinking largely sobers us again.

This wisdom is taken from Alex’s Essay on Criticism, which celebrates its three hundredth birthday next month. It’s a lesson that Tax Court taught to Bruce A. and Carol Anfinson Brown, 2011 T.C.Mem.83, filed 4/12/11.

Carol has an LL.M. in tax and is an active State court practitioner. Bruce is a commercial litigation attorney. Their problem started when the loans on Bruce’s life insurance policy with Northwestern Mutual (The Quiet Company) exceeded the cash value (the sum of any dividends plus paid-up value from Northwestern’s tables plus the value of any additional insurance bought with accumulated dividends).  Bruce at first used dividends for additional insurance, but stopped doing so. He then started to use dividends to offset premiums and finally started borrowing against cash value to pay ongoing premiums.

Bruce reported no income from the dividends or the loans, and rightly so (Section 72(e) (4) (B)). But finally Bruce stopped paying, and Northwestern quietly canceled the policy and sent Bruce a 1099-R showing a gain of $29,093.30, being the difference between what Bruce had paid (investment in the contract) and what he had borrowed.

Believing that Northwestern had erroneously determined that the gain was the result of cancellation of indebtedness, Bruce and Carol did not report the $29,093.30 from the 1099-R amount on their 1040, and did nothing else.

Right in theory, because the loan wasn’t canceled, it was paid in full by using the cash value of the policy,  but wrong on the law. The pay-in-full is a taxable event, per Section 72(e) (5) (A) and (C), which cancel the general rule of Section 72(e) (4).

Carol and Bruce’s argument, that Section 72(e)(4)(B) exempted the 1099-R amount from tax on the grounds that it was a dividend taken back by Northwestern, is rejected decisively by Judge Morrison–right church, wrong pew. The operative sections are Section 72(e) (5) (A) and (C). The excess of cash value over Bruce’s investment was not received as an annuity and therefore is subject to tax, as the loan was a true loan, and the effect of using its cash value to pay off a loan against the cash value is the same as if Northwestern had written a check  to Bruce, and Bruce wrote a check back to Northwestern.

Carol and Bruce’s argument that in the controlling cases cited by Tax Court the policyholders used the loan proceeds for purposes other than premium payments, which Bruce did not, doesn’t avail them. It doesn’t matter,  says Judge Morrison; a debt is a debt is a debt. And a debt from a loan against an insurance policy’s cash value, if paid off otherwise than as an annuity, generates gain to the extent of excess of debt over investment in the contract.

Carol and Bruce did get one minor gimme: the deficiency stated in the 90-day letter was less than the number IRS proved at trial. But Tax Court hadn’t jurisdiction to enter judgment for the greater amount (several hundred dollars), because IRS didn’t assert a greater amount at or before the hearing (Section 6214(a)).

As for penalties, Tax Court assesses the substantial understatement penalty because, in Judge Morrison’s words: “The Browns exerted little effort. They understood correctly that there was no discharge of debt. They therefore concluded that Northwestern’s information return, which they misconstrued as having been based on a discharge-of-debt theory, was wrong. Yet they did not research the proper tax treatment of the transaction. They did not even make the simple effort of asking Northwestern why it reported income where there was no discharge of debt. And, finally, the Browns’ experience, knowledge, and education weigh against them: both are licensed attorneys, and one has a master of laws degree (LL.M.) in taxation. In short, the Browns have failed to show that they had reasonable cause for and acted in good faith regarding the underpayment.” 2011 T.C. Mem. 83, at pp. 24-25.

And wouldn’t cancellation of debt be reported, not on a Form 1099-R, but on a Form 1099-C?

Bottom line: No matter what your expertise, do your homework. In fact, the more your expertise, the more you should do your homework. A little learning is an expensive, as well as a dangerous, thing.

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