Tax Court Holds Policy Loan Discharge on Terminated Life Insurance Contracts Creates Taxable Income

In Fugler v. Commissioner, T.C. Summ. Op. 2025-10 (Nov. 17, 2025), the U.S. Tax Court addressed the tax consequences of terminating whole life insurance policies with outstanding policy loans. The decision reinforces long-standing principles governing the taxation of policy surrenders and loan discharges, and it illustrates the limited scope of defenses available when taxpayers fail to report amounts shown on Forms 1099-R.

The taxpayer had purchased two whole life insurance policies on the lives of his children. Over the years, he borrowed against the policies, taking out lump-sum loans and subsequently borrowing additional amounts to pay ongoing premiums. By 2018, the outstanding loan balances on both policies exceeded the cash surrender value. When the taxpayer surrendered the policies, the insurer issued a Form 1099-R reporting gross distributions that included both cash paid to the taxpayer and the discharged loan balances. The form also reported taxable amounts resulting from the termination of the policies with outstanding indebtedness. The taxpayer did not include any portion of the distribution in income on his 2018 return, prompting the IRS to issue a notice of deficiency along with an accuracy-related penalty.

In the ensuing Tax Court litigation, the taxpayer advanced several arguments, all of which the court rejected. First, he contended that the income resulting from the policy terminations was properly reportable in a different tax year. The court disagreed, holding that the taxable event occurred in 2018, the year both policies were surrendered and the loan balances were extinguished. Consistent with established precedent, the court explained that when a life insurance contract is terminated and outstanding loans are discharged, the discharged indebtedness is treated as part of the policy proceeds and included in gross income in the year of termination to the extent it exceeds the taxpayer’s investment in the contract.

The taxpayer next argued that he was entitled to deduct the interest on the policy loans as business interest expense. The court found no evidence that the loans were used for a trade or business and noted that the taxpayer had provided no documentation connecting any of the borrowed amounts to business activities. Without substantiation or a valid business purpose, the court concluded that the taxpayer was not entitled to any deduction for interest paid or accrued on the policy loans.

Finally, the taxpayer sought innocent spouse relief under section 6015(f). Although the Commissioner conceded that equitable relief was available to the taxpayer’s spouse, the court held that the taxpayer himself did not qualify. Section 6015(f) provides relief only to spouses seeking protection from joint liability due to the other spouse’s actions, and the taxpayer failed to demonstrate that he met the statutory and regulatory criteria. Because he was the spouse responsible for the unreported income and erroneous positions taken on the joint return, he was not eligible for relief.

Having rejected each of the taxpayer’s arguments, the court sustained both the deficiency and the accuracy-related penalty under section 6662. The opinion underscores the importance of properly reporting distributions reflected on Forms 1099-R, including taxable amounts attributable to the discharge of policy loans at surrender. It also highlights the narrow circumstances under which taxpayers may claim business-interest deductions or obtain innocent spouse relief when they themselves controlled the transactions at issue.

Taxpayers with life insurance policies encumbered by loans should be aware of the potential income tax consequences upon policy surrender or lapse. When loan balances exceed the taxpayer’s basis in the policies, termination will often result in taxable income, even if no cash is actually received. If you have questions about this update or require estate and tax planning advice, please contact Liskow attorneys Leon Rittenberg III, John Rouchell, Caroline Lafourcade, and Kevin Naccari and visit our Tax practice page.