Braun: Life Insurance Lapsed to Term After Missed Premiums, and the Form 1099-R Income Was Taxable

When a whole life policy that has been borrowed against is converted to term insurance after missed premiums, the policy’s cash value above the premiums paid can be taxable income even though no check arrives. In Braun v. Commissioner, No. 25467-21S, the Tax Court sustained $115,551 of 2018 income reported on a Northwestern Mutual Form 1099-R, but it rejected the 20% accuracy-related penalty because the IRS never produced the supervisory-approval or electronic-calculation evidence its lawyer said she would provide.

Special Trial Judge Diana L. Leyden gave the ruling from the bench on October 20, 2026, the day after trial in Tampa, and the transcript was served November 5. Robert E. Braun represented himself. The case was heard as a small tax case under section 7463. Under section 7463(b), a small tax case decision cannot be reviewed by any other court.

Two policies, borrowed against, then converted

Beginning in 1977, he bought life insurance from Northwestern Mutual, understanding that if he paid premiums until age 65 he would receive annuity payments. After his income dropped, he borrowed against two of the policies in 2004 to cover personal expenses and keep paying premiums.

At 65 he asked about the annuity. Northwestern Mutual told him the policies did not provide one, and that he had either been given wrong information by the agent or misunderstood it. He stopped paying premiums sometime during or before August 2018.

In August and December 2018 the insurer wrote that it had converted the two borrowed-against policies from whole life to term insurance. The letters said each policy’s cash value exceeded the premiums paid, and that the differences, totaling $115,551.99, would be reported to the IRS as taxable income. They also said he might “be able to avoid this taxable income” by paying the outstanding premiums to restore the previous coverage within the tax year of the change. He did not restore the coverage or reject the conversion.

The Form 1099-R reported a 2018 gross distribution of $214,291.52, of which $115,551.99 was taxable. The letters said the cash value paid off his loans, and the court noted that the loan repayment did not create additional taxable income.

A note on the return, without evidence, did not shift the burden

Mr. Braun timely filed his 2018 return and attached a note saying he was not reporting the taxable amount shown on the Form 1099-R. The IRS examined the return through its Automatic Underreporter System and, in an April 2021 notice of deficiency, determined $115,551 of unreported income from Northwestern Mutual plus $98 of unreported interest, a $29,202 deficiency and a $5,840 penalty under section 6662(a). In his timely Tax Court petition, he said he did not receive “even $1.00” from the insurer in 2018.

The court started from the ordinary rule: the notice of deficiency is presumed correct, and the taxpayer must prove it wrong. Mr. Braun had not argued or shown that the burden shifted to the IRS under section 7491(a).

The court also considered section 6201(d). If a taxpayer asserts a reasonable dispute about income on a third-party information return and has fully cooperated with the IRS, the IRS must produce reasonable and probative information beyond the form itself. After trial, the court found that Mr. Braun had provided no evidence to support a reasonable dispute about the accuracy of the Form 1099-R, so the IRS could rely on it.

Why the conversion produced income

Gross income includes income from life insurance contracts under section 61(a), and the section 101(a) death-benefit exclusion did not apply. Under section 72(e)(5)(A) and (C), as the court applied it, policy proceeds not paid as a death benefit are income only to the extent they exceed the policyholder’s basis, which generally includes the premiums paid.

The court treated the policy loans as genuine loans from the insurer to the policyholder. Relying on an earlier Tax Court memorandum opinion and section 72(e), it explained that when cash value exceeds the net investment in the policy, the policyholder has ordinary income in the amount of the cash value minus the premiums paid. Here, after the premiums stopped, Northwestern Mutual used the cash value of the two policies to buy term insurance, and that cash value was greater than the premiums Mr. Braun had paid. He was enriched by the difference, and he had not shown that any exception applied.

His main answer was that Northwestern Mutual committed “fraud” in selling the policies and converting them. He acknowledged, however, that he never took steps to reverse the conversion and never brought an administrative or legal action against the insurer. The court sustained the $115,551 of 2018 income from the conversion.

Why the penalty failed

Under section 7491(c), the IRS bears the burden of production on the 20% section 6662(a) penalty, asserted here for a substantial understatement. As the court described section 6751(b), the IRS also had to produce evidence that the penalty was either approved by the examiner’s supervisor or automatically calculated through electronic means and so exempt from supervisory approval. The IRS’s lawyer said at trial that she would provide that evidence, but she did not. The court held Mr. Braun not liable for the $5,840 penalty.

Result, status and what the case means

The court ruled for the Commissioner on the deficiency and for Mr. Braun on the section 6662(a) penalty. Its November 5 order called for decision to be entered under Rule 155.

Our reading: the tax in Braun came from the policy, not from cash in hand. Northwestern Mutual’s letters said the income might be avoided by paying the outstanding premiums to restore coverage within the tax year of the change, and Mr. Braun did not do so; a policyholder who gets a similar letter should read its terms and deadline closely. Otherwise, a challenge to the Form 1099-R needs records, such as premium history and the insurer’s cash-value and basis figures, rather than a note on the return or a complaint about the sale. A claim against the insurer is a separate matter from the tax.

The penalty ruling turned on this trial record. Even in an underreporter case, the IRS had to come forward with that evidence; a record that included it could come out the other way. Our guide to an unresolved CP2000 and the 90-day Tax Court deadline explains the notice steps before a case like this reaches court.