Brown v. Commissioner

In the

United States Court of Appeals

For the Seventh Circuit

No. 11-2508

B RUCE A. B ROWN and C AROL A NFINSON B ROWN,

Petitioners-Appellants,

v.

C OMMISSIONER OF INTERNAL R EVENUE,

Respondent-Appellee.

Appeal from the United States Tax Court

No. 6825-08—Richard T. Morrison, Judge.

A RGUED M AY 25, 2012—D ECIDED S EPTEMBER 11, 2012

Before P OSNER, FLAUM, and W OOD , Circuit Judges.

P OSNER, Circuit Judge. The Tax Court ruled that the

petitioners, a married couple filing a joint return, had

underpaid federal income tax for 2005 by $8,553. The

court assessed a deficiency equal to that amount and

tacked on a penalty of $1,711 (20 percent of the deficiency,

the IRS apparently having rounded off $1710.60 to $1711).

The basis of the deficiency was the taxpayers’ failure

to include in their taxable income for that year income

2 No. 11-2508

realized by Mr. Brown upon the cancellation of a $100,000

life insurance policy that he owned, a whole life policy

issued to him by Northwestern Mutual Life Insurance

Company in 1982. In such a policy the insured pays a

constant annual premium and the policy pays the same

death benefit whenever he dies. Since he is more likely

to die when he gets older yet the policy premiums

don’t increase as he ages, the insurance company must

charge a premium that produces an overcharge in the

early years in order to build up a store of value that

will defray the cost of paying the death benefit in later

years, which is when death is more likely, and the

death benefit therefore more likely to become payable,

than in the earlier years. The sum of the overcharges is

called the policy’s “cash value,” and the policyholder can

borrow against it either for personal reasons or to pay

future premiums. Alternatively, by canceling the policy,

which he can do at any time, he is entitled to receive the

cash value (called in that event the “cash surrender” value)

less any outstanding loans against it. See 1 Robert H. Jerry,

II, New Appleman on Insurance Law Library Edition,

§ 1.08(b)(ii) (2012). He is also entitled to the cash sur-

render value if the insurance company, rather than

he, cancels the policy, as the company is entitled to do

if his borrowing from the company exceeds the cash

value—in which event, however, he will owe the

company more than it owes him.

An insurance company doesn’t just sit on a policy-

holder’s premium payments, of course; it invests them;

and as is the practice of mutual insurance companies,

No. 11-2508 3

Northwestern Mutual credits part of the income from

investing them to the policyholder’s account with the

company and calls these credits “dividends.” Northwest-

ern Mutual, “Company Overview: What Mutuality

Means to You,” www.northwesternmutual.com/about-

northwestern-mutual/our-company/company-overview.

aspx#Mutuality (visited Aug. 21, 2012); see Indianapolis

Life Ins. Co. v. United States, 115 F.3d 430, 431 (7th Cir.

1997); Prairie States Life Ins. Co. v. United States, 828 F.2d

1222, 1223-24 (8th Cir. 1987). Brown’s policy gave him a

choice among receiving his dividends in cash, using

them to pay future premiums, or—the default option

specified in the policy—buying additional life insurance

above the face amount of the policy ($100,000 in

Brown’s policy). Because he made no selection among

these alternatives, by default the dividends were used

to increase his life insurance.

The policy required an annual premium of $1,837.

From 1982 to 1986 Brown paid in cash, but from 1987

to 2000 he paid by borrowing against the policy’s cash

value, with the result that his indebtedness to the insur-

ance company increased. From 2001 through 2003, with

his indebtedness approaching the policy’s cash value,

he paid half the premiums in cash and the rest by bor-

rowing from the company. Nevertheless in 2004 his

indebtedness exceeded the policy’s cash value, and he

surrendered the additional insurance that he had ob-

tained by applying his dividends to the purchase of addi-

tional insurance and he directed that future dividends

be used to pay premiums and pay back his accumulated

4 No. 11-2508

debt to the company. But by the end of 2005 the amount

he had borrowed from the insurance company again

exceeded the policy’s cash value (though only by

$30.42), and this time the insurance company cancelled

the policy, as the terms of the policy entitled it to do.

The $31,063.30 of additional insurance that Brown

surrendered in 2004 and the $4,869.94 of dividends sub-

sequently applied at his direction to pay premiums

and repay debt in that and the following year are at the

heart of the litigation. The position of the Internal

Revenue Service, seconded by the Tax Court, is that

these moneys (totaling $35,933.24) are value that Brown

received from the policy before it was cancelled.

Therefore they reduce by this amount his net “investment

in the [insurance] contract” (the sum of all premiums that

the policyholder paid minus any amounts he received

before he surrendered the policy upon its cancellation by

the insurance company or by his own choice, 26 U.S.C.

§ 72(e)(6)). That is a reduction in net investment

from $44,205.00 to $8,271.76 ($44,205.00 – $35,933.24).

According to the terms of the policy, the policy had a

cash value of $37,356.06 at the time of surrender.

An investment of $8,271.76 that makes the policy worth

$37,365.06 on surrender generates $29,093.30 ($37,365.06 –

$8,271.76) in taxable income. But Brown contends that

really he invested the full $44,205 in the contract (the

policy) within the meaning of the applicable tax law—that

that amount should not be diminished by the $35,933.24

in additional insurance and dividends received—and

that therefore he realized a net loss when the policy was

No. 11-2508 5

cancelled, and so no tax is due. Naturally he is loath to

pay any tax in respect of the cancellation, since he

received no money from it.

The cash value of a surrendered (whether or not volun-

tarily surrendered) life insurance policy is includable in

gross income “to the extent it exceeds the [taxpayer’s]

investment in the [insurance] contract,” 26 U.S.C.

§ 72(e)(5)(A), and is taxable as ordinary income. Barr v.

Commissioner, No. 8705-08, 2009 WL 3617587, at *3 (U.S. Tax

Ct. Nov. 3, 2009); see also Wolff v. Commissioner, 148 F.3d

186, 189-90 (2d Cir. 1998). When Brown’s policy was

cancelled, its cash value was $37,365.06. What had he

invested in the policy? That is, what was his cost (his

“basis,” in tax-speak)? Remember that he had paid a total

of $44,205.00 in premiums but had received $35,933.24

from surrendering the additional insurance in 2004 and

from using dividends to pay premiums and loans in 2004

and 2005. The difference of $8,271.76 was the net cost to

him of the cash surrender value of the policy, and sub-

tracting the $8,271.76 cost from that value resulted in

taxable gross income of $29,093.30, just as the Tax Court

ruled, even though Brown had received no cash because

the cash value of the policy had been used to pay off the

loans that he had gotten from the company to pay for

his premiums. E.g. Feder v. Commissioner, No. 1628-10, 2012

WL 75114, at *4 (U.S. Tax Ct. Jan. 10, 2012); Sanders v.

Commissioner, No. 3395-09, 2010 WL 5327897, at *2 (U.S. Tax

Ct. Dec. 20, 2010); McGowen v. Commissioner, No. 14116-07,

2009 WL 4797538, at *4 (U.S. Tax Ct. Dec. 14, 2009), af-

firmed on other grounds, 438 Fed. Appx. 686 (10th Cir.

2010).

6 No. 11-2508

Brown claims that the $35,933.24 in additional insurance

and dividend payments was (or was equivalent to)

“dividends . . . retained by the insurer as a premium or

consideration paid for the [insurance] contract,” which 26

U.S.C. § 72(e)(4)(B) excludes from gross income. But

that section is inapplicable to payments under life in-

surance policies. It is captioned “special rules for ap-

plication of paragraph (2)(B),” and that paragraph does

not apply to non-annuity life insurance payments.

26 U.S.C. §§ 72(e)(5)(C), (e)(5)(A)(i).

The gross income calculated by the Tax Court was the

amount by which the cash value of Brown’s insurance

policy exceeded what he’d paid for the policy. The fact

that this income was used to pay a debt to the insurance

company is irrelevant, because it was a personal

rather than a business debt and therefore was not de-

ductible. 26 U.S.C. § 61(a); 26 U.S.C. §§ 163(a), (h); Kikalos

v. Commissioner, 190 F.3d 791, 793-94 (7th Cir. 1999). It is

also irrelevant that no money changed hands—that the

debt was paid by the creditor’s withholding money

otherwise due the debtor, like a setoff. See, besides the

Feder, Sanders, and McGowen opinions cited above, Barr

v. Commissioner, supra, 2009 WL 3617587, at *2, and

Atwood v. Commissioner, No. 19748-97, 1999 WL 109617, at

*2 (U.S. Tax Ct. Mar. 4, 1999).

The Tax Court’s result may seem odd because it

seems not to account for the cost that Brown (and the

beneficiary of the life insurance policy, his wife) incurred

when he was credited, upon cancellation of the policy,

with the policy’s cash surrender value. The cost incurred

was the value of the death-benefit component of the

No. 11-2508 7

policy, which (obviously) evaporated when the policy

was cancelled.

But the oddness is superficial. As time passes and the

cash surrender value of a whole-life policy grows, the

net death benefit, which is the face amount of the

policy (the proceeds on death) minus the premiums

paid, shrinks as a result of the growing stock of premiums

paid, to the point at which further premium payments

(which remember were fixed at $1,837 a year) can

actually reduce the net death benefit. By surrendering

the policy (albeit involuntarily) Brown gave up the pros-

pect of receiving $100,000 if he died but at the same

time freed himself from having to pay $1,837 each year

to maintain that prospect.

It remains only to consider the penalty for the under-

statement of tax. The 20 percent penalty for substantial

understatement of income tax, 26 U.S.C. §§ 6662(a), (b)(2),

(d), has an exception for the case in which the taxpayer’s

position was supported by “substantial authority.”

§ 6662(d)(2)(B)(i); see Kim v. Commissioner, 679 F.3d 623,

626 (7th Cir. 2012); TIFD III-E, Inc. v. United States, 666

F.3d 836, 848-50 (2d Cir. 2012). As defined with great

specificity in a Treasury Regulation the validity of which

is not challenged, the term “substantial authority” is

limited to statutes, regulations, judicial decisions, con-

gressional floor statements and committee reports,

revenue rulings and procedures, tax treaties, private

letter rulings, and certain IRS publications. Treas. Reg.

§ 1.6662-4(d)(3)(iii).

There is a compelling reason for limiting the eligible

authorities as tightly as the regulation does: otherwise

8 No. 11-2508

demand by taxpayers would evoke “authorities” for every

position that a taxpayer might wish to take. The

authorities on which the taxpayers in this case rely

either do not support their position or aren’t on the list.

Even if there isn’t substantial authority in support of a

taxpayer’s position, he can avoid the underpayment

penalty if he made reasonable efforts to determine his

tax liability. 26 U.S.C. § 6664(c); Treas. Reg. §§ 1.6662-4(a),

1.6664-4(b). Generally this requires that he have ob-

tained an opinion from an accountant or lawyer. United

States v. Boyle, 469 U.S. 241, 250-51 (1985); Mulcahy,

Pauritsch, Salvador & Co. v. Commissioner, 680 F.3d 867,

872 (7th Cir. 2012). The taxpayers in this case are an

attorney couple who made no effort to research the

legal basis for their position, or obtain an opinion from

an accountant or lawyer, until the Internal Revenue

Service challenged their position. So they didn’t reach

the safe harbor.

A FFIRMED.

9-11-12