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Tax Liability on Phantom Income

Example 1
In 1990 a couple in their forties procured a $5,000,000 survivor whole life policy on a 10 premium payment assumption of $40,000 a year. The in-force ledger showed that under current dividend and expense projections the premium would reappear at $400,000 a year (that is not a typo) if they didn’t “die on time”.
If the premium at that time was not paid and the policy lapsed, the internal loan created by this “short pay” scenario would be taxed as ordinary income under the forgiveness of debt rules. At the projected point of collapse, the loan totals $12,000,000 of which roughly $10,000,000 would be taxable as phantom income at ordinary tax rates. Obviously lapsing the policy would not be an option as it would generate a multi million dollar tax.
Our Policy Audit highlighted this potentially devastating development and we brought them solutions.
Example 2 
A couple in their Fifties put a survivor whole life policy for $2,000,000 in force a decade ago and they have stopped paying on it as originally illustrated.
By age 80, the premiums reappear to the tune of $50,000 plus a year.
In that year there is a $2,500,000 loan. Roughly $2,000,000 of it would be phantom income if the premiums are not paid and the policy lapses.
Example 3
In the eighties, a couple put $40,000 each into a single pay variable life policy on each of themselves. It was sold to them as an investment and over the years the cash value grew and they took money out periodically.
In 2009 they received a notice from the insurance company they owed money to keep the loan amount below the cash value.
The short story is that the policies collapsed with a $450,000 1099 of which $370,000 was "phantom gain" taxed at ordinary income tax rates.
Example 4
We received a call from an attorney whose business owner client was experiencing some financial duress and was eyeing his life insurance policy as a source of capital. The client wanted to cash the policy in an take advantage of the $500,000 of cash value to make ends meet and pay down some debt.
The advisor had the foresight to pick up the phone and ask us about this. We stated that the first thing to do was to determine if there was any taxable gain. It turned out that the gross cash value was $1,200,000 and the policy had a $700,000 loan which netted the $500,000 of cash value he had his eyes on. 
The policy had a tax basis of $600,000 which meant that upon surrender the policy would have generated a $600,000 gain (the spread between the gross cash value and the tax basis).
The problem in most scenarios like this is that the phone call is never made to the advisor and the client would call the insurance carrier directly to surrender the policy, spend his $500,000 and then get blindsided with the 1099 in January and owe roughly a quarter million to the IRS in April, which he doesn’t have because he had no idea the policy surrender was a taxable transaction.
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