Business Owner Taxed on Life Insurance Policy Loan Used to Prop Up Business

(Parker Tax Publishing May 2026)

The Tax Court held that a businessman who borrowed against a life insurance policy in order to keep his company afloat, was taxable on those distributions when the company went out of business and the policy was cancelled. However, the court concluded that a portion of the interest paid on the loans was deductible as investment interest and that the business owner was not liable for the Code Sec. 6651(a)(2) failure-to-pay penalty because his financial difficulties were not the result of negligence but instead arose because he could not realistically borrow to satisfy his tax liability given his financial history. Sawyer v. Comm'r, T.C. Memo. 2026-33.

Background

From 1979 until its liquidation in 2010, Jonathan Sawyer (Sawyer) owned and operated Henry N. Sawyer (HNS), a family printing business dating back to 1835. In 1982 he purchased a life insurance policy (Policy) on himself from Northwestern Mutual Life Insurance Co. (Northwestern). Depending on the liquidity of the business, he would either pay the quarterly life insurance premium in cash or allow Northwestern's automatic premium loan provision to cover the quarterly premium. In 2009, Sawyer took out an $80,000 loan secured by the value of the Policy in an attempt to keep HNS afloat.

Even after HNS's shuttering, Sawyer continued receiving correspondence from Northwestern regarding the Policy; all of that paperwork was addressed to him and reflected him as the Policy's owner. He believed the paperwork to be in error and, in 2013, made one attempt to contact the agent for his account but was advised by Northwestern that the agent no longer worked there. Sawyer took no further action to clarify the Policy's ownership with Northwestern. A notice of cancellation was sent to Sawyer on July 26, 2015. According to Northwestern, the cash surrender value of the Policy at that time was $205,434 and it was used to satisfy the outstanding indebtedness on policy loans from Northwestern.

Sawyer did not file a tax return for his 2015 tax year. He received Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., from Northwestern reporting that he received a taxable distribution of $160,900. Because he believed the Form 1099-R to be inaccurate, Sawyer consulted with a number of tax attorneys concerning the proper tax reporting with respect to the constructive distribution. However, he did not receive a clear answer and ultimately did not file a federal income tax return. The IRS prepared a substitute for return (SFR).

In a Notice of Deficiency relating to Sawyer's 2015 tax year, the IRS determined a tax deficiency of $50,150, a Code Sec. 6651(a)(1) penalty of $10,463 for failing to timely file, a Code Sec. 6651(a)(2) addition to tax of $11,625 for failing to timely pay, and a Code Sec. 6654 addition to tax of $830 for failing to make sufficient estimated tax payments.

Sawyer took his case to the Tax Court. The issues before the court were (1) whether Sawyer constructively received $160,900 (the difference between the $205,434 value of the life insurance policy and Sawyer's $44,534 investment in the contract) from Northwestern in 2015 upon the termination of the Policy and, if so, whether he was entitled to deduct investment interest; and (2) whether Sawyer was liable for penalties for the failure to timely file and pay additions to tax.

Sawyer contended that, in 2015, the defunct HNS owned the Policy and was therefore entitled to the Policy's cash surrender value and responsible for the Policy's loans. Sawyer based his argument on the decision in Clark v. Comm'r, T.C. Memo. 1997-209, in which the Tax Court held that a third party performing services and ultimately receiving the resultant income was subject to taxation on that income. Sawyer also argued that the interest paid on the loans was deductible as investment interest to the extent the proceeds (1) from the Policy Loan were invested into HNS and/or (2) from the Premium Loan paid for the investment aspect of the life insurance contract.

Analysis

The Tax Court held that (1) Sawyer constructively received taxable income of $160,900 from Northwestern upon the termination of the Policy; (2) Sawyer was entitled to a deduction of so much of the $40,107 investment interest paid as does not exceed his net investment income; and (3) Sawyer was liable for the Code Sec. 6651(a)(1) failure-to-file addition to tax but not the Code Sec. 6651(a)(2) failure-to-pay addition to tax.

The court concluded that Sawyer was taxable on the indirect distribution of the taxable portion of his insurance contract because under Code Sec. 72(e)(5), gross income includes nonannuity amounts received under a life insurance contract in excess of the investment in the contract. Code Sec. 72(e)(6), the court noted, defines investment in a contract as the amount of premiums paid less amounts received under the contract that were excludable from gross income. The court, citing its decision in Atwood v. Comm'r, T.C. Memo. 1999-6, observed that it had previously addressed the fact that the indirect distribution of an insurance policy's cash surrender value is gross income under Code Sec. 72. Thus, although Sawyer did not receive any cash because the entirety of the Policy's value had been applied against the outstanding loans, the court found that he is nonetheless treated as having received a taxable constructive distribution of $160,900.

The court then addressed Sawyer's argument that interest paid on the loans was deductible as investment interest. The court found that Sawyer's investment in HNS was to keep the business afloat, ultimately earning income that would lead to dividends. Thus, the court concluded that the HNS stock was property held for investment, and the underlying interest paid to support that investment was investment interest expense.

However, the court noted, such investment interest expense was likewise subject to the limitations of Code Sec. 163(d)(1), which provides that, in the case of a taxpayer other than a corporation, the amount allowed as a deduction is limited to the net investment income of the taxpayer for the tax year. Thus, as to the $40,107 of interest on the $80,000 Policy Loan that was satisfied in 2015 with an offset to Sawyer's cash surrender value, the court concluded that it was deductible only to the extent of net investment income for the 2015 tax year.

With respect to the deductibility of the premium loan interest on the theory that the life insurance contract has both insurance and investment characteristics, the court found no evidence of how the interest should be allocated between the contract's insurance aspect and its investment aspect and thus did not allow it. The court cited a report from the Joint Committee on Taxation Report (General Explanation of the Tax Reform Act of 1986, JCS-10-87) which states that "personal interest includes, for example, interest on a loan to purchase an automobile, interest on a plan to purchase a life insurance policy."

Finally, with respect to the failure to file penalty, the court found unreasonable Sawyer's excuse that he was unsure of the proper reporting position and thus found him liable for the penalty under Code Sec. 6651(a)(1). However, the court concluded that Sawyer had reasonable cause with respect to his Code Sec. 6651(a)(2) failure-to-pay addition to tax because his financial difficulties were not the result of negligence but instead arose because he could not realistically borrow to satisfy his tax liability given his financial history.

For a discussion of the taxation of terminated life insurance policies, see Parker Tax ¶71,920.

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