Taxes in your practice: US Tax Court finds whole life insurance termination taxable

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.

The U.S. Tax Court recently held that taxpayers had taxable income resulting from termination of whole life insurance policies, a consideration that tax lawyers should keep in mind when serving their clients.

In Fugler v. Commissioner of Internal Revenue,¹ the tax court found that when a couple terminated whole life insurance policies with outstanding loans, they received constructive distributions from the policies that were includible in their gross income.

Background 

In 1987, David and Cindy Fugler purchased whole life insurance policies from Mass Mutual insuring their two children. The Fuglers were the owners and beneficiaries of the policies, which required annual premiums of $150 per year until each child’s 65th birthday or their death, whichever occurred first. The policies also allowed borrowing against cash surrender value. 

From 1988-2006, the Fuglers paid the annual premiums. In 2006, they borrowed $10,500 from one policy and $11,000 from the other policy. From 2007-2016, the Fuglers borrowed from the policies to cover the annual premiums. Interest on these loans also was added to the loan balances on each policy. By 2018, the policies had loan balances of $19,845 and $20,699. 

The policies also had cash surrender values which increased over time from accumulated dividends but were reduced by the outstanding policy debts. In 2018, the Fuglers notified Mass Mutual of their intent to terminate the policies. Mass Mutual provided surrender forms and advised them that surrender could result in taxable income. The Fuglers submitted the surrender forms and received checks for $3,033 and $2,729 with respect to the policies.

Mass Mutual reported the distributions to the Fuglers on Form 1099-R, indicating taxable income with respect to each policy, calculated as the gross distribution, including the checks distributed and the outstanding loan balance, reduced by insurance premiums paid. For one policy, this resulted in a $16,028 taxable amount. For the other policy, it was a $16,578 taxable amount. The Fuglers did not report income from Mass Mutual on their 2018 tax return.

The IRS proposed an increase to the Fuglers’ income for the taxable amounts on the Mass Mutual Form 1099-R, and the Fuglers pursued relief in tax court. The issues in the case were: 

(1) whether the policy distributions were includible in the Fuglers’ 2018 taxable income, 
(2) whether the Fuglers were entitled to a deduction for interest paid on the policy loans, and 
(3) whether the Fuglers were entitled to innocent spouse relief under Internal Revenue Code § 6015.²

Statutory background and tax court analysis 

Code § 61 defines “gross income” as income from any source including “income from life insurance and endowment contracts.” Code § 72 further provides that amounts received under annuity, endowment, or life insurance contracts are included income, and amounts received from nonannuity life insurance contracts are income to the extent they exceed investment in the contract. 

The tax court also cited prior cases for the concept that loans against life insurance policy cash value are loans from the insurance company to the policyholder, and these loans are not taxable distributions when received. However, the tax court stated that a taxpayer constructively receives proceeds from a terminated life insurance policy to the extent that existing policy loans are satisfied from the policy’s cash value, citing Mallory v. Commissioner of Internal Revenue.³ 

In Fugler, the tax court, therefore, found that the taxpayers constructively received proceeds in the amount of the outstanding loan balances that were satisfied upon termination of the policies. The tax court held that the Fuglers’ taxable income for 2018 included these constructively received policy loan balances in addition to the checks received for the remaining cash value of each policy.

The tax court next addressed the Fuglers’ claim for interest expense deductions. The Fuglers claimed the proceeds of the policy loans were used in connection with their mining and logging business. The commissioner stated the interest was nondeductible personal interest. Section 163(h) disallows a deduction for personal interest, unless the interest is identified in §163(h)(2), which includes categories such as interest relating to a trade or business, investment, qualified residence, etc. However, the tax court found the Fuglers offered no evidence to show they were engaged in a mining and logging trade or business and no evidence that the loan proceeds were used for that purpose. As a result, the tax court held that the interest paid on the policies was nondeductible personal interest.

Finally, the tax court recognized that the IRS had conceded Cindy Fugler was entitled to innocent spouse relief. The tax court also confirmed that innocent spouse relief is only available to one spouse in response to David Fugler raising a similar claim.

Conclusion 

Fugler demonstrates why lawyers should remind their clients to carefully consider the tax implications in terminating insurance policies with outstanding policy loans. In some cases, it may make more economic sense to maintain the policies until death of the insured so that nontaxable death benefit proceeds repay the loans. 

Fugler also reminds taxpayers that interest deductions are only available for specific categories, like a trade or business, and that taxpayers must be able to demonstrate use of loan proceeds relating to the category in question for deductibility.

Endnotes 
1 Fugler v. Commissioner of Internal Revenue, T.C. Summ.Op. 2025-10 (U.S. Tax Ct., 2025). 
2 § 6015. Relief from joint and several liability on joint return, 26 USCA § 6015. 
3 Mallory v. Commissioner of Internal Revenue, T.C. Memo. 2016-110 (U.S. Tax Ct., 2016).