A single person onws and upside down universal life policy (7 pay). That will be surrendered. Tax Problems?

[Guest optjjm]

A single person profit sharing plan held a universaal life policy purchased under a 7 pay plan. Paid about 28K in premiums (deductible). Never paid another cent (I guess this was a vanishing premium policy (with a vanishing agent too)), Needless to say the policy self-sustained for several years. Plan member took out a 35K loan in 1997. Never paid any interest everything was covered. Loan principal and interest grew to 59K. Participant paid in a $2,000 in payments (not deducted) to keep everything in force. This year the plan will surrender the policy and the Profit Sharing plan will reveive about $1,000.

Question: Participant wants to eventually close the plan because a new one was established and covers the participant and employees. Participant wants to follow the rules (although the 50% Universal Policy limitation may have been violated in the late 80's) He wants to follow the law and report any distribution required. He is over 59.5 so no early withdrawl penalties exist.

The carrier is not issuing a 1099. Should he report a distribution of 35K or is tax due on the entire 59K. To take it one step further; I thought he should maybe pay off the loan with other sources. Then take a loan for 50K from the profitsharing plan secured by the primary residence and can pay th eloan back overtime. Also would this loan qualify for 30 yrear amortization??

[Bird]

Ugh. Sounds like this is FUBAR'd. But, this board is about helping each other out, so I'll try.

Paid about 28K in premiums (deductible).

For the record, I object. He made profit sharing contributions that were deductible and chose to invest them in a life insurance policy.

Plan member took out a 35K loan in 1997.

Mmm, you mean he personally borrowed from the policy? (i.e. the money didn't just go to another investment in the plan - it doesn't sound like it.) That's a plan loan; I wonder if it exceeded the limits at the time and was documented (ha-fat chance!). In any event, it sounds like it defaulted for lack of repayment.

Participant paid in a $2,000 in payments (not deducted) to keep everything in force.

Oh, it gets better! Are these loan repayments (on a defaulted loan) or after tax contributions (permitted by the plan?).

I think I have changed the definition of the problem (improper loan and/or default - a long time ago). If I misinterpreted, I'm sorry.

Setting that aside for a moment, the surrender of the policy by the plan (with proceeds going back into the plan) is not a taxable event. It's really just like any other asset of the plan (if you sold XYZ mutual fund there would be no consequences either). It's only when money leaves the plan that taxes are incurred. But in this case, it sounds like they left the plan a long time ago.

[Guest optjjm]

To answer some reply's. He took out a loan for 35K. He never paid anything into the policy again. He made other plan contributions. It seems like the plan lost value because he did not repay the loan. You could argue that he owes tax on the entire 59K .

Once the policy was underwater he funded 2 separate payments of about 1000 each. These payments were out of pocket and nothing was deducted. This year he is surrending the policy. He knows that he will need to pay tax on at least the loan amount. (Like a 401k when the employee leaves the position without re-paying their loan).

Concerned that he might get hit for the entire outstanding loan amount of 59K.

You brought up some very good points. If you sell assets in a plan for a loss, there is no tax issue. Are you taxed on the accrued interest. The insurance company is treating it like any other sale of a plan asset where the money goes back into the plan, so thye are not going to issue a 1099.

You also brought up another good point. He probably put more than 50% of the plan contributions into insurance originally. No documentation on that. Also, since the loan is now in excess of 50K and may have been more than 50% of the plan value many moons ago, he may be FUBAR.

He just wants to be straight up with the tax people, but does not want to go belly up

Any additional thoughts. (I may tell him to report 35K and consult his tax advisor)

[Bird]

The gross outstanding loan of $59,000 isn't relevant, IMO.

I think the issue is that he effectively took a distibution from the plan, some time ago, for $35,000 and didn't report it. Then he made an after-tax contribution to the plan of $2,000 that probably wasn't permitted.

The surrender of the policy and loan offset, with receipt of $1,000, is not a reporting/triggering event of any kind, except in his mind.

If he wants to feel better about it he could report $33,000 now. It wouldn't be right, except that if he looks at what should have been reported over the last "x" years vs. what is actually reported now, it will balance out - sort of. (Not counting the time value of money and/or premature distribution penalties, if applicable.)