                        T.C. Memo. 2009-285



                      UNITED STATES TAX COURT



     BILL S. MCGOWEN AND CAROLYN M. MCGOWEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 14116-07.              Filed December 14, 2009.



     Harold A. Chamberlain, for petitioners.

     Thomas Fenner, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     PARIS, Judge:   Respondent determined an income tax

deficiency of $171,631 for petitioners’ 2004 tax year.

Respondent conceded the section 6662 penalty.   The two remaining

issues are:   (1) Whether petitioners’ income as a result of the

termination of a variable life insurance policy should be
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characterized as income from a life insurance contract pursuant

to section 72(e) or income from the discharge of indebtedness;

and (2) whether petitioners’ income, if derived from the

discharge of indebtedness, should be excluded from their gross

income pursuant to section 108(g).

     All section references are to the Internal Revenue Code in

effect for the year in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated.

                         FINDINGS OF FACT

     Some of the facts were stipulated.     The stipulation of

facts, together with the exhibits attached thereto, is

incorporated herein by this reference.

     Bill S. McGowen (Mr. McGowen) and Carolyn M. McGowen (Mrs.

McGowen) are husband and wife, and they filed a joint Federal

income tax return for the year 2004.   At the time the petition

was filed, they resided in New Mexico.

     On May 30, 1986, Mrs. McGowen purchased a single-premium

variable life insurance policy (insurance policy) on her own life

for $500,000.   Upon her death, the insurance policy would have

conferred on the beneficiary a benefit in excess of the policy

debts she incurred.   The death benefits consist of the return on

the investments made by the insurer and the guaranteed amount.

According to the insurance policy, the insurer invests in mutual
                                 - 3 -

funds1 exclusively.    The insurer purchases, sells, and holds the

shares of the mutual funds, but does not manage them.     The

insurer purchases shares in the mutual funds from separate

investment advisers if that mutual fund satisfies the insurance

policy’s restrictions and objectives and sells them if the mutual

fund ever fails to meet those standards.     In contrast, the

guaranteed amount is determined on the basis of the year the

beneficiary receives the benefit.     In the initial year, the

beneficiary will receive solely the guaranteed amount.     For all

subsequent years the benefit will vary in accordance with the

positive return of the investment in the mutual fund but will not

be less than the guaranteed amount.

     Mrs. McGowen had the right to cancel the insurance policy

and receive its net cash value.2    The insurance policy defines

the net cash value as the cash value3 minus any policy debt.     The

policy debt consists of the sum of all outstanding loans plus

accrued interest.     The insurance policy permits Mrs. McGowen to



     1
      A mutual fund is an investment company that pools money
from the sale of its corporate shares and invests the money in
stock, short-term money market instruments, and other securities.
     2
      The net cash value at the time of cancellation is also
referred to as the net cash surrender value.
     3
      The insurance policy defines cash value using a calculation
where “the cash value on a date equals the tabular cash value on
the date plus the net single premium on that date for the
Variable Insurance amount.” Tabular cash value refers to the
value shown on the insurance policy’s schedule B.
                                - 4 -

borrow money at a 5.25-percent annual interest rate.    Any unpaid

interest due at the end of the policy year will be added to the

amount of the loan.    The insurance policy further requires that

the insurance policy itself serve as collateral and that the

insurance policy terminate if the policy debt ever exceeds the

cash value.

    The insurance policy states that any amount borrowed by the

insured would cause a withdrawal of that exact amount from the

investment base and an allocation of that fund to a separate

general account.    Any fund directed to the separate general

account would earn a 4.5-percent annual rate of return.

    On May 31, 1989, Mrs. McGowen first exercised her right to

borrow $25,000 from the insurance policy to pay her personal

expenses.   On the same day, she received a letter from the

insurer indicating that her investment base, net cash surrender

value, and death benefits would be decreased by $25,000.    In a

letter dated June 29, 1989, the insurer sent another monthly

notice reporting Mrs. McGowen’s total loan balance of $50,104.28

based upon an additional $25,000 borrowed by Mrs. McGowen and the

accrued interest of $104.28.    Mrs. McGowen would continue to

receive these monthly notices throughout the life of the

insurance policy.    Over the next year, Mrs. McGowen borrowed

monthly amounts ranging from $5,000 to $25,000, totaling $235,000

by April 1990.   On June 1, 1990, Mrs. McGowen made a $7,444.22
                                - 5 -

payment, which was applied towards the interest accrued on the

loans.   From June 11, 1990, to April 8, 1991, Mrs. McGowen

borrowed additional amounts totaling $216,000.   In January 1992

she borrowed her last amount of $2,500.   In addition, the insurer

also sent yearly reports stating that the amounts Mrs. McGowen

borrowed had accrued annual interest of $39,553.15 for the year

1998, $41,629.69 for the year 1999, $43,815.25 for the year 2000,

$46,115.55 for the year 2001, $48,536.62 for the year 2002, and

$51,084.79 for the year 2003.   Those annual interest notices

stated in bold that the interest due would be added to her

outstanding loans if she did not make any payments.   Last, Mrs.

McGowen received letters each year stating that if she

surrendered her insurance policy by a date certain she would

incur a taxable gain.   Those letters indicated that on May 28,

1999, May 30, 2000, May 29, 2001, May 28, 2002, and May 28, 2003,

she would have incurred a taxable gain of $413,124.30,

$456,684.62, $480,124.92, $506,400.60, and $536,831.59,

respectively.   Additionally, the record demonstrated that the

insurer corresponded with Mr. McGowen, apprising him of the

financial history of Mrs. McGowen’s insurance policy.

     By 1992 Mrs. McGowen had borrowed amounts totaling $536,500.

Before the cancellation of the insurance policy,   Mrs. McGowen

had made only the one payment of $7,444.22 on June 1, 1990.     In

September 1993 Mrs. McGowen did make an inquiry regarding the
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surrender of her policy but apparently chose not to act.     By 2000

the interest accrued on the policy debt had drastically exceeded

the diminishing return rendered by both the investment base and

the general account.    Consequently, the already reduced net cash

surrender value of the insurance policy continued to shrink

rapidly.   The insurance policy had net cash surrender values of

$78,293.21 on May 28, 2000, $55,617.96 on May 28, 2001,

$33,357.02 on May 28, 2002, and $12,703.22 on May 28, 2003.     By

November 28, 2003, the monthly statement had indicated that the

net cash surrender value had been diminished to $2,782.25.

     On March 1, 2004, the insurer issued a notice warning Mrs.

McGowen that her outstanding policy debt had exceeded the

insurance policy’s cash value as of February 28, 2004, and the

termination of the insurance policy would occur within 31 days if

she did not make a payment of $108,313.42.   That notice also

stated that the cancellation of the insurance policy would be a

taxable event, whereby she would have to recognize $562,746.04 as

of February 28, 2004.   Interest would still accrue during the 31-

day grace period.   Mrs. McGowen did not make the payment.   On

March 30, 2004, the insurer sent a letter informing Mrs. McGowen

of the cancellation of the insurance policy and the issuance of

an Internal Revenue Service Form 1099-R, Distributions From

Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs,

Insurance, Contracts, etc., reporting a gain of $565,224.11.
                                - 7 -

                               OPINION

Burden of Proof

     Respondent’s determinations in the notice of deficiency are

presumed correct, and petitioners bear the burden of disproving

those determinations.   See Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933).

Issue 1. Gross Income

     Gross income includes all income from whatever source

derived.   Sec. 61.   Section 61 lists specifically some forms of

gross income, including the income from a life insurance contract

and the income from a discharge of indebtedness.    See sec.

61(a)(10), (12).   Neither party disputes that petitioners have

received income as a result of the termination of their variable

life insurance policy and that petitioners intended to report

that income on their 2004 joint return.   The parties’ dispute

concerns the kind of income petitioners received.    A variable

life insurance contract is a permanent form of insurance in which

the cash value is based on the performance of an underlying pool

of securities.    See Much v. Pac. Mut. Life Ins. Co., 266 F.3d

637, 638 (7th Cir. 2001).   The Court holds that petitioners

received income attributable to the termination of their variable

life insurance policy pursuant to section 72(e).
                               - 8 -

     Petitioners argue that their income arose from the discharge

of Mrs. McGowen’s indebtedness of $1,065,224.11.   The Court

respectfully disagrees.

     For Federal income tax purposes, petitioners’ policy loans

were true loans.   See Atwood v. Commissioner, T.C. Memo. 1999-61.

The parties have agreed to this fact, and the Court concurs.    The

insurance policy required by its terms the payment of a 5.25-

percent interest rate on amounts borrowed against the policy, a

requirement indicative of a bona fide debt.   See Salley v.

Commissioner, 55 T.C. 896, 903 (1971), affd. 464 F.2d 479 (5th

Cir. 1972); Kay v. Commissioner, 44 T.C. 660, 670-672 (1965);

Dean v. Commissioner, 35 T.C. 1083, 1085 (1961).   Consequently,

petitioners would not have had to recognize these loans as

taxable income when they received them.   See Commissioner v.

Indianapolis Power & Light Co., 493 U.S. 203, 207-208 (1990);

Commissioner v. Tufts, 461 U.S. 300, 307 (1983).

    Petitioners did not receive income from discharge of

indebtedness.   A discharge of indebtedness occurs when “the

debtor is no longer legally required to satisfy his debt either

in part or in full.”   Caton v. Commissioner, T.C. Memo. 1995-80;

see also United States v. Centennial Savings Bank FSB, 499 U.S.

573, 580-581 (1991).   On the basis of facts presented, the Court

cannot characterize the source of petitioners’ income as income

derived from the discharge of indebtedness.   The record here
                                - 9 -

indicates that the loans to Mrs. McGowen were not discharged:

they were extinguished after the insurer had applied the cash

value of the insurance policy towards the debt owed by Mrs.

McGowen.    The insurance policy itself was the sole collateral for

which the insurer can seek repayment of the amount Mrs. McGowen

borrowed.   Consequently, the insurance policy mandates the

immediate surrender of the insurance policy once the amount

borrowed against the policy exceeds the cash surrender value.

Petitioners had been fairly warned by the numerous letters

notifying them of the increasing possibility of the cancellation

of Mrs. McGowen’s insurance policy.

     The present record instead supports the characterization of

petitioners’ income as income received from a life insurance

contract.   Any distribution from Mrs. McGowen’s insurance policy

would fall within the purview of section 72(e)(1).   Section

72(e)(1) mandates that a taxpayer include in his gross income any

amount that is received under an annuity, endowment, or life

insurance contract and is not received as an annuity.   Section

72(e)(5) limits this inclusion to the amount exceeding the

investment in the contract.   Investment in the contract as of any

date will be the difference between the aggregate of premiums or

other consideration paid for the contract before such date, and

the aggregate amount received under the contract before such date

to the extent that such amount was excluded from gross income.
                              - 10 -

Sec. 72(e)(6).   The Court cannot conclude that Mrs. McGowen

received any direct distributions from her life insurance policy.

Nevertheless, for the following reasons, the Court holds that

petitioners must recognize the indirect distribution of income

Mrs. McGowen received from her insurance policy under section

72(e).

     A taxpayer may be required to recognize an indirect

distribution of an insurance policy’s cash value as gross income

under section 72.   This Court reached that conclusion in Atwood

v. Commissioner, supra, among other cases.   Each of the married

taxpayers in Atwood purchased an individual life insurance

policy, paying a single premium.   See id.   Those taxpayers each

borrowed the maximum amount permitted by their insurance policies

yet did not make any loan payments, causing those policies to be

terminated.   Upon the termination of the husband’s policy, the

insurer issued to the husband a check in the amount by which the

cash surrender value of his policy exceeded his loan.   The wife

did not receive a check upon termination of her policy because

her loan had exceeded the cash surrender value of her policy.

Both taxpayers received a Form 1099 reflecting gain from the

surrender of their insurance policy.   This Court held in Atwood

that the taxpayers received gross income under section 72(e).

This Court reasoned that the taxpayers had received a deemed
                                - 11 -

distribution to the extent of their satisfied loans and explained

further:

             When petitioners’ policies terminated, their
        policy loans, including capitalized interest, were
        charged against the available proceeds at that time.
        This satisfaction of the loans had the effect of a pro
        tanto payment of the policy proceeds to petitioners and
        constituted income to them at that time. * * *


Id.    Any conclusion otherwise “would permit policy proceeds,

including previously untaxed investment returns, to escape tax

altogether and finds no basis in the law.” Id.

      Similar to the taxpayers in Atwood, petitioners must

recognize the indirect distribution from Mrs. McGowen’s insurance

policy as gross income under section 72(e).    The insurer applied

the cash value of Mrs. McGowen’s insurance policy to extinguish

her loan.    This would then have the same effect as the “pro tanto

payment” described by this Court in Atwood.    Furthermore, this

Court maintains that the distributed policy proceeds attributed

to the return on investments must be taxed since the accruals on

the investments were not previously taxed.    Untaxed accrual on an

investment is often referred to as inside buildup.

      Pursuant to section 72(e), petitioners must recognize

$565,224.11 as gross income, based upon the difference between

Mrs. McGowen’s investment in the contract and the cash value of

the policy on the date of cancellation.    The cash value at the

time of surrender was $1,065,224.11, which, by the contractual
                              - 12 -

terms, cannot be less than the aggregate of all the amounts

borrowed by Mrs. McGowen and the accrued interest.   Mrs.

McGowen’s investment in the contract was $500,000.   Also, the

excess of the insurance policy’s cash surrender over the cost of

the contract would be attributable to the previously untaxed

inside buildup which Mrs. McGowen must now recognized as income

of $565,224.11.

Issue 2. Exclusion From Gross Income

      Petitioners have raised the issue of whether the income, if

derived from the discharge of indebtedness, should be excluded

from their gross income under section 108(g).   This issue is moot

because the Court has held that Mrs. McGowen’s debts were not

discharged and, thus, petitioners’ income was not from discharge

of indebtedness.


                                           Decision will be entered

                                       for respondent.
