Northwestern Whole Life Policy Creates Tax Disaster - Again

Originally Published on forbes.com on January 19th,2012

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Life insurance is a tax favored vehicle.  The build-up in value is tax deferred and payments by reason of the death of the insured or in a qualified viatical settlementare income tax free.  Given all that, it is amazing how often life insurance ends up creating tax problems for people.  Of the eight unfair tax decisions I highlighted for 2011, two concerned whole life policies.  So it is not surprising that another one came out early in 2012.  The dollars are not huge, just a little over $1,713 in tax, but the facts in the case of Yulia Feder are supremely annoying.  They are annoying enough that I am going to absolutely prove that I could never be a Tax Court judge.

The Story

Yulia Feder purchased a $50,000 life insurance policy from Northwestern Mutual Life Company in August 1982.  She paid $73 per quarter.  In January 1988, she sent Northwestern a letter indicating that she wanted to cancel the policy.  She expected that they would send her some forms.  When she received nothing from them, she assumed that the policy had been cancelled.

It turned out that Northwestern either never received her letter or just did not act on it.  Not only that, the $1,500 or so that she had paid Northwestern had created some value.  Northwestern had no idea as to where Ms. Feder was, but in accordance with the policy terms they loaned her $73 of her own money which they then paid to themselves to keep the $50,000 policy in force.  The $50,000 was in my mind a low risk proposition since they would not have known if she had died.  This went on until 2007, when finally the loan exceeded the value of the policy.  The loan wiped out the policy value of $12,654.  The basis in the policy was $7,029 making her taxable on $5,625.  It is not like she got a check for $5,625.  That would be the non-deductible interest on the loan of her own money that Northwestern had used to pay itself for not really taking any risk.

The Decision

Ms. Feder did not learn about the 1099 Northwestern issued from Northwestern.  She found out from the IRS.  Her argument was that she had cancelled the policy 20 years ago and had not heard from Northwestern since.  Sounds pretty solid to me, but it was not good enough for the Tax Court.  Part of the problem is that the burden of proof was on her not the IRS:

To prove that the Form 1099-R properly and accurately reported petitioner’s 2007 taxable income, respondent introduced a declaration from the assistant director of policyowner services at Northwestern .  The declaration includes petitioner’s premium loan history and the 2009 correspondence. The declaration also explains how Northwestern calculated the figures on the Form 1099-R.

“Assistant director of policyowner services” ?? – If that is what the assistant director does, what does the director do ? Drown puppies.

The factual issue in this case is whether petitioner canceled herlife insurance policy in January 1988. Under New York law,  an insured must cancel the policy pursuant to the terms of the policy.

Petitioner did not present any evidence that she canceled the life insurance policy pursuant to its terms. Petitioner credibly testified that she sent a letter to Northwestern requesting that it cancel her policy. She did not, however, introduce the policy or testify to its terms, and without evidence as to the terms of the policy we do not know whether the letter was an effective means of canceling the policy.

Surprisingly, given the small stakes, Ms. Feder had counsel.  They are the ones that are supposed to be watching that burden of proof and evidence stuff.  I’m not going to knock them though.  I reserve my wrath for Northwestern.

How I Would Have Ruled

I would have said to the IRS that Ms. Feder never asked to borrow any money.  Northwestern says she has $5,625 in income. Great.  Go make Northwestern cut her a check for $5,625 and they can withhold taxes from her and that is how you will get paid.  If you can’t do that, then just leave her alone and go fight crime someplace else. So ends my career as a Tax Court judge, but it would have been satisfying.

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