The recent financial crisis brought the income tax consequences of a cancellation of debt out into the public consciousness. A lot of mortgage borrowers found themselves unable to make their payments, and lenders found it necessary to rework some mortgages so that people could make their payments and stay in their homes. While having part of their mortgage debt cancelled looked like an unqualified positive for the borrowers, they soon found out that a cancellation of debt (COD) can have dramatic income tax consequences for a borrower.
Cancellation of Debt and Life Insurance
Although the mortgage crisis brought the income tax treatment of debt cancellation into the public consciousness, many taxable cancellations of debt take place outside the mortgage arena. COD income can be a very serious problem for insureds in both the stranger-originated life insurance and policy loan contexts.
Stranger-Owned Life Insurance
COD has become a serious problem for some life insurance trusts and their grantors. As the popularity of life insurance policies as an alternative investment class kicked up over the last decade, supply of policies through life and viatical settlements couldn’t keep up with investor demand. A new method for moving life insurance policies into investor hands was needed. Along came Stranger-Owned Life Insurance (STOLI, also referred to as Stranger-Originated Life Insurance and other similar names).
In a STOLI transaction, an individual is recruited by investors or a third party to purchase a life insurance policy on his or her own life and then transfer it to investors. In some cases, the mechanism by which the policy was transferred was a premium finance loan. The individual would–with the help of the STOLI promoter–fill out a life insurance application. Once issued, premiums would be paid through a premium finance loan. Under the terms of the loan, the insured had the right to hand back the policy to the lender in exchange for a cancellation of the premium finance debt. The policy would then be owned by the lender, who would sell it to investors (or the lender may have been the lender itself).
As you can guess, the cancellation of debt is generally taxable to the insured. And considering the massive premiums on the large face value policies used for STOLI, the COD income can create income tax liability of hundreds of thousands of dollars for insureds who never intended to purchase a life insurance policy or take out a premium finance loan to finance needed life insurance.
Cancellation of Debt when a Policy is Cancelled with an Outstanding Loan
Another situation where a cancellation of debt can result in an unexpected tax bill for insureds is when a life insurance policy is cancelled while a policy loan is outstanding.
Life insurance is sold as a tax-efficient way to pass wealth on to the next generation. But despite that death benefits are paid out without being subject to income tax, the tax free status of life insurance doesn’t extend much further. For instance, the death benefit of a policy that is owned at death is included in the decedents estate. There are also situations where lifetime transactions involving a policy can create a big tax bill for insureds.
If a policy is cancelled while policy loans are outstanding that the insured will not repay, the insured will be subject to income tax on the amount of the loan that is outstanding at the time the loan is cancelled less the taxpayer’s investment in the contract.
Insured (and their advisors) are frequently surprised to find out that they dropped into an income tax sinkhole by the simple act of cancelling their life insurance policy or choosing not to continue making premium payments to keep the policy in force.
A Cancellation of Debt Doesn’t Always Equal Income–The Insolvency Exception
The good news is that there are ways to avoid paying tax on a COD–the exclusion for insolvent or bankrupt taxpayers; the bad news is that you have to be in a financial bind to qualify for the exclusion.
A cancellation of debt won’t be added to a taxpayer’s taxable income if the debtor was insolvent or in bankruptcy at the time the debt was cancelled. Fortunately, the solvency calculation takes into account the cancelled debt when determining whether the taxpayer is solvent.
For many people that got caught up in a STOLI scheme or who cancelled a policy with an outstanding loan not realizing they would be on the income tax hook, the insolvency exception will be the only thing keeping them from a massive income tax bill that they can’t hope to pay. The astronomical debt cancellation that came along with many STOLI schemes will often be enough to push the insured into insolvent territory and save them from the IRS.
Calculating insolvency is not as simple as lining up assets on one side of a ledger and debts on the other and seeing whether debts are greater than assets. The calculation is much more complicated and requires knowledge of the Tax Code.
If you (or one of your clients) is facing a huge tax bill resulting from a COD, call our firm at 937-298-8600 to speak with an attorney about whether the insolvency exception could help you to avoid an enormous tax bill.