Court: Mistaken Loan Default Payment Is Taxable

May 20, 2003 ( -Withdrawals made from plan annuity contracts to repay a default on a loan, regardless if the contracts were assigned by mutual mistake between the plan participant and the lending bank, are a taxable event for the participant.

>The US District Court for the District of North Dakota ruled the law of contracts governs the assignment issue. Under this law, a mutual mistake renders a contract not void, but voidable. Avoidance of such a contract would generally require that one of the parties take action, according to Washington-based legal publisher BNA.

In this case, the plaintiff did not challenge the validity of the assignment, which was executed approximately 13 years ago, and steps were taken to revise or rescind the underlying loan agreement.   However, the tax consequences can be levied after the plaintiff enjoyed tax benefits for the 13-year period, since the Internal Revenue Service (IRS) based the tax on the realities of the transactions that were carried out.

Tax Switch

>Larry Armstrong, president and sole shareholder of National Marketing Company Inc., arranged for a short-term loan in the amount of $134,000 with Thomas Gietzen, an assistant vice president with Midwest Federal Savings Bank of Minot, North Dakota.   To fulfill the request, Gietzen asked for, and Armstrong agreed to provide, life insurance policies as collateral for the loan.

>Armstrong directed Gietzen to go to his office to pick up his life insurance policies. However, Armstrong’s secretary gave Gietzen two retirement plan annuity contracts (retirement policies) owned by National Marketing and issued by UNUM Life Insurance Company of America in lieu of Armstrong’s life insurance policies. The loan documents were then prepared with these documents, which assigned National Marketing’s retirement policies to Midwest Federal. Armstrong had signed these documents before Gietzen filled in the collateral information.

>When Armstrong learned of the error, he contacted Gietzen, offering to return the loan. Gietzen acknowledged the error and assured Armstrong that Midwest Federal would consider the loan unsecured. However, National Marketing’s underwriter, UNUM, recorded the assignment of the retirement policies to Midwest Federal.

Deemed Default

>In the fall of 1990, the Resolution Trust Corp. (RTC) took over Midwest Federal. Armstrong’s loan came due on November 15, 1990. Armstrong defaulted on the loan and failed to pay despite a demand letter from RTC. In June 1991, RTC proceeded to withdraw $159,375.53 from the UNUM retirement policies to repay Armstrong’s loan. Despite being notified by RTC of the withdrawal, Armstrong did not include the withdrawal amount as income on his tax return.

>However, the IRS assessed taxes, penalties, and interest against Armstrong for 1989 and 1991, pursuant to Section 72(p)(1) of the Internal Revenue Code, on the basis that the assignment of the retirement policies to Midwest Federal had resulted in taxable income to Armstrong. Armstrong paid the assessments and then sued for a refund.

>Armstrong did not dispute the application of Section 72(p)(1) but claimed that money withdrawn from National Marketing’s retirement policies should not have been taxed as a disbursement because the underlying assignment of the retirement policies had resulted from a mutual mistake of fact and therefore was invalid. The parties filed cross motions for summary judgment.

>The court granted summary judgment for the government, since Armstrong had enjoyed the tax benefits for the previous 13 years, regardless of the error and subsequent acknowledgement thereof.

The case is Armstrong v. United States , D. N.D., No. A4-02-042, 4/25/03.