UNITED STATES TAX COURT
STEPHEN L. AND COLLEEN ATWOOD, Petitioners v
.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19748-97. Filed March 4, 1999.
Stephen L. and Colleen Atwood, pro sese.
James F. Prothro
, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, Judge
: Respondent determined a deficiency of $10,756 in petitioners’ 1995 Federal income tax and an accuracyrelated penalty in the amount of $2,151 pursuant to section 6662. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year at issue, and all Each of the policies permitted the owner to borrow generally up to the amount of policy cash value, using the policy as security. Each contract required payment of a specified rate of interest on amounts borrowed, with any accrued but unpaid interest to be added to the loan and to bear interest at the same rate. Each contract provided for the termination or lapse of the policy when the total loan, including unpaid interest, exceeded the policy cash value (the value of the single premium accumulated with interest less certain specified charges). Because of financial hardship and in order to pay personal living expenses, petitioners each borrowed the maximum allowable amounts against their policies. They each failed to completely repay these loans or interest thereon, resulting in the termination of each policy in 1995.
When First Colony terminated petitioner husband’s policy, his outstanding loan balance, exclusive of certain unpaid interest, was $39,403.63. The policy had a cash value of $39,843.11, and a cash surrender value of $439.48 ($39,843.11 minus $39,403.63). Upon termination, First Colony sent petitioner husband a check in the amount of the cash surrender value ($439.48). First Colony also issued petitioner husband a Form 1099-R, reflecting a taxable gain of $14,843.11, which the company computed as the cash value of $39,843.11, less his investment in the contract of $25,000.
When National Western terminated petitioner wife’s policy, her outstanding loan balance was $73,274.49. National Western issued petitioner wife a Form 1099-R, reflecting a taxable gain of $23,274.49, which the company computed as the outstanding loan balance of $73,274.49, less her investment in the contract of $50,000.
On their 1995 joint Federal income tax return, petitioners reported no taxable distributions from their terminated insurance policies. Respondent determined that petitioners had income of $14,843 from the First Colony policy and $23,274 from the National Western policy.
OPINION
In general, with exceptions not applicable here, any amount which is received under a life insurance contract or endowment contract before the annuity starting date and which is not received as an annuity is included in gross income to the extent it exceeds the investment in the contract. Sec. 72(e)(1)(A), (5)(A), (C). The investment in the contract is defined generally as the aggregate amount of premiums or other consideration paid for the contract less aggregate amounts previously received under the contract, to the extent they were excludable from gross income. Sec. 72(e)(6).
The derivation and computation of the amounts reported on the Forms 1099-R by First Colony and National Western upon T.C. 655, 661-667 (1986)(advances for interest that were added to the nonrecourse mortgage principal, pursuant to the terms of the mortgage, constituted a true debt obligation), affd. 856 F.2d 1169 (8th Cir. 1988).
When petitioners’ policies terminated, their policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to petitioners and constituted income to them at that time. See Minnis v. Commissioner , supra at 1056 (dictum); Caton v.
Commissioner
, T.C. Memo. 1995-80; Dean v. Commissioner , T.C.
Memo. 1993-226. A contrary result would permit policy proceeds, including previously untaxed investment returns, to escape tax altogether and finds no basis in the law.
Petitioners argue that if the distributions on the terminated insurance policies are taxable, then they should be allowed an offsetting deduction for interest paid on the policy loans. Deductions are a matter of legislative grace, and petitioners bear the burden of showing that they are entitled to the claimed deductions. Rule 142(a); INDOPCO, Inc. v. Commissioner , 503 U.S. 79, 84 (1992). Section 163(a) generally allows as an interest deduction all interest paid or accrued within the taxable year on indebtedness. As an exception to this general rule, however, in the case of a taxpayer other than a was nondeductible personal interest under section 163(h), however, the issue is moot.
We hold, therefore, that petitioners are taxable on distributions from their terminated policies in the amount of $38,117 and are not entitled to deductions for interest paid on their policy loans.
Substantial Understatement of Income Tax
Respondent also determined an accuracy-related penalty under section 6662 for a substantial understatement of tax for taxable year 1995. Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment of tax attributable to, among other things, a substantial understatement of income tax, which is defined as an understatement that exceeds the greater of 10 percent of the tax required to be shown or $5,000. Sec. 6662(d)(1)(A). Petitioners reported total tax of $6,231 and understated their tax in the amount of $10,756. Therefore, there was a substantial understatement of tax.
Any understatement is reduced to the extent that it is attributable to an item that was adequately disclosed and has a reasonable basis, or for which there was substantial authority for its tax treatment. Sec. 6662(d)(2)(B). Notwithstanding that petitioners were issued Forms 1099-R indicating taxable distributions upon termination of their insurance policies, petitioners made no disclosure on their return of the relevant facts affecting their exclusion of these amounts from gross income. See sec. 6662(d)(2)(B)(ii)(I). Petitioners have established no substantial authority for excluding these amounts from income.
Accordingly, we sustain respondent’s imposition of the accuracy-related penalty.
To reflect the foregoing, Decision will be entered for respondent .