Life Insurance Proceeds

[Randy Watson]

Assume a participant fails to include the current cost of life insurance protection in income for a number of years. If the participant dies, would the life insurance proceeds that exceed the cash surrender value still be excluded from income of the beneficiary or does the failure to include the current cost somehow blow that exclusion?

[rcline46]

Failure to include cost of life insurance protection (PS 58 or group term) makes the proceeds taxable.

[Belgarath]

Do you have any citation to support that opinion? I'm not necessarily disagreeing (because I don't know the answer with any certainty) but I lean toward a different interpretation.

I believe that the fact an employee does not properly declare and pay the income tax on the taxable term cost does not override the otherwise applicable income tax treatment of the life insurance proceeds. 1.72-16©(1)(i) says "...and the employee either paid the cost of the insurance or was taxable on the cost of the insurance under paragraph (b) of this section..."

I don't read ©(4) of that regulation as contradicting the above interpretation.

I couldn't find any Revenue Rulings (but I certainly could have missed one) that state the entire proceeds are income taxable due to a failure to declare taxable term cost.

If you have such a situation, I'd certainly run this by a good ERISA/tax attorney, as the tax consequences of an incorrect answer could be rather large depending upon the amounts of insurance involved.

[rcline46]

Ahhh, the fine nuances of what it said! 'or was taxable' as you pointed out is the operative phrase here, and you need an attorney to give you the 'correct' interpretation.

IMHO if the participant did not report the premium as taxable, then they the premium was not taxable. They should have been given a 1099-R if the policy were in a plan, or have have in included on the W-2 if group term. The IRS would have matched up the 1099-r and found a failure to report.

The penalty for failure to report is inclusion of death proceeds as ordinary income.

[Peter Gulia]

Beyond any look at the statutes and regulations, consider whether the doctrine of the taxpayer's duty of consistency precludes him or her from taking a position that's inconsistent with the position in earlier years' tax returns.

[Belgarath]

Hmmm - I don't know anything about the consistency doctrine, so I'll have to bypass that one.

I agree that the IRS is likely to find a failure to report. And I would expect this to be treated like underreporting any other taxable income - taxes and penalties on the underreported amount are owed. But I still can't find anything that says the specific penalty for failure to report results in taxation of the entire death benefit.

I wonder - pure speculation here - IF the IRS were to assert this, which I think is by no means certain - and the taxpayer went to tax court, what the result would be? That seems like a penalty not comparable to most insignificant underreporting incidents. For example - $300,000 death benefit, 1st year so no cash value, and the TTC is - pick a number - say $2,000. By underreporting $2,000, you subject $298,000 to an otherwise inapplicable income tax - easily could be $70,000+. That sure is an awfully hefty penalty!

Oh well. I've never seen this, and I'm sure I never will, but I enjoy running through the arguments each way. Thaks for the discourse.

[Bird]

I'm not sure on the answer either but I lean towards Belgarath's position. There was a problem with all those years of unreported income, but I don't know that the consequence or "fix" is that 100% of the proceeds are now taxable.