IRS Issues Rulings to Clarify Tax on Sale or Surrender of Life Insurance Policies

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Author:Amy R. Lonergan, Esq., Edwards Angell Palmer & Dodge LLP

On May 1, 2009, the Internal Revenue Service (“IRS”) issued two revenue rulings to address particular tax consequences of the sale or surrender of a life insurance policy. Revenue Ruling 2009-13 deals with the tax treatment of an individual who sells or surrenders a life insurance contract on his own life. Revenue Ruling 2009-14 focuses on investors, and addresses the taxation of death benefits and gains realized on the resale of life insurance contracts, as well as the taxation of death benefit proceeds paid to foreign investors. Both revenue rulings provide legal conclusions through the use of varying but related fact patterns, as summarized below.

Rev. Rul. 2009-13: Tax Consequences to the Insured
Situation 1: An individual (“Insured”) entered into a life insurance contract with cash value on his own life. Eight years into the contract, Insured paid premiums totaling $64,000, and the cash value of the contract was $88,000. Insured surrendered the policy and received $78,000 after the issuer collected $10,000 of surrender and other charges incurred under the policy (“cost-of-insurance”).

The surrender value received by Insured is included in his gross income to the extent it exceeds his investment in the contract, which is the $64,000 in premiums paid. Therefore, Insured must recognize $14,000 of ordinary income ($78,000 net cash surrender value less $64,000 premiums paid).

Situation 2: The facts of Situation 2 are the same as in Situation 1, except that Insured sold the life insurance contract for $80,000 to an unrelated person who otherwise would suffer no economic harm upon Insured’s death.

Insured must recognize as income the excess, if any, of the sale proceeds received over his investment in the contract. For this purpose, Insured’s investment in the contract is equal to the premiums paid by Insured, reduced by the cost-of-insurance (i.e. the surrender and other charges that would have been incurred if the policy was then surrendered instead of sold to a third party). The IRS explains that the basis must be reduced by the cost-of-insurance charges because such costs represent the continuing insurance protection that was part of the consideration offered in exchange for the contract. Insured paid total premiums of $64,000 and his cost-of-insurance charges were $10,000, resulting in an adjusted basis of $54,000. Insured received $80,000 from the proceeds of the sale, and therefore must recognize $26,000 of income ($80,000 less $54,000).

Whether Insured’s $26,000 of income is categorized as ordinary income or capital gain depends on an application of the “substitute for ordinary income” doctrine, which is limited to the amount that would be recognized as ordinary income if the contract were surrendered (the “inside build-up” under the contract). To the extent the income recognized on the sale exceeds the inside build-up under the contract, the excess is characterized as capital gain. The inside build-up of Insured’s life insurance contract was $14,000 ($78,000 cash surrender value less $64,000 in premiums paid). Therefore, of Insured’s $26,000 of income, $14,000 is ordinary income, and the remaining $12,000 is long-term capital gain.

Situation 3: The facts of Situation 3 are the same as in Situation 1, except that the contract was a term life insurance contract without cash surrender value. Insured’s premium for the contract was $500 per month. Insured paid a total of $45,000 in premiums through June 15 of the eighth year of the contract, at which point he sold the contract for $20,000 to an unrelated third party who would suffer no economic harm upon Insured’s death (“Buyer”).

As stated in Situation 2, the adjusted basis of a life insurance contract is equal to the total premiums paid less the cost-of-insurance. For a term life insurance contract, the cost-of-insurance is presumed to be the aggregate premiums paid under the contract, absent other proof. In most scenarios, the adjusted basis will equal zero, or a modest amount of prepaid premiums.

Here, the cost-of-insurance provided to Insured was $500 (Insured’s monthly premium) multiplied by 89.5 (number of months that Insured held the contract), or $44,750. Insured’s adjusted basis in the contract on the date of sale was $250 ($45,000 total premiums paid by Insured, less $44,750 cost-of-insurance). Insured must recognize $19,750 as income ($20,000 proceeds received less $250 adjusted basis). Term life insurance has no cash surrender value, and therefore there is no inside build up under the contract to which the substitute for ordinary income doctrine may apply. Thus, Insured’s $19,750 of income is categorized as long-term capital gain.

Rev. Rul. 2009-14: Tax Consequences to an Investor
Situation 1: One June 15, 2008, an investor (“Buyer”) purchased a life insurance contract from Insured for $20,000. The contract was a term life insurance contract on Insured’s life with a monthly premium of $500. The contract was issued by a corporation located in the United States (“Issuer”). Insured died on December 31, 2009 and Buyer collected the $100,000 death benefit paid by Issuer. Buyer paid a total of $9,000 in premiums to keep the contract in force.

Amounts received under a life insurance contract paid by reason of the death of the insured generally are not included in gross income. However, if the life insurance contract was transferred for valuable consideration, § 101(a)(2) provides that the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration and premiums paid by the transferee.

Buyer’s purchase of the life insurance contract from Insured was a “transfer for valuable consideration” under § 101(a)(2), which states that the amount excluded from gross income shall not exceed the sum of the actual value of the consideration paid for the transfer ($20,000) and the premiums subsequently paid by Buyer ($9,000). Therefore, Buyer must include $71,000 in his gross income ($100,000 death benefit received less $29,000 in consideration and premiums paid). While the life insurance contract purchased by Buyer is a capital asset, the receipt of death benefit proceeds on a life insurance contract is not a sale or exchange of a capital asset. Therefore, the $71,000 income recognized by Buyer is ordinary income.

Situation 2: The facts of Situation 2 are the same as Situation 1, except that Insured does not die and Buyer sells the contract to a third party unrelated to both Insured and Buyer for $30,000 on December 31, 2009.

In determining Buyer’s adjusted basis in the contract, the premiums paid by a secondary market purchaser of a term life insurance contract must be capitalized; that is, Buyer’s basis in the contract is increased by the total premiums paid by Buyer to keep the contract in force. In contrast to the treatment for the insured as set forth in Rev. Rul. 2009-13, Buyer’s basis in the contract is not reduced by the allocable cost-of-insurance.

Buyer realized $30,000 from the sale of the life insurance contract. Buyer paid $20,000 to acquire the contract, and subsequently paid $9,000 in monthly premiums, resulting in an adjusted basis of $29,000. Therefore, Buyer must recognize $1,000 of long term capital gain income, as the contract was a capital asset held for more than one year and then sold.

Situation 3: The facts are the same as in Situation 1, except Buyer is a foreign corporation not engaged in a trade or business in the United States. In this scenario, the death benefit payable by a U.S. insurance company to the non-U.S. investor upon the death of a U.S. citizen would be considered U.S. source income. As in Situation 1, Buyer must recognize $71,000 of ordinary U.S. source income, which qualifies as “fixed or determinable annual or periodical” income under § 881(a)(1). Buyer is subject to withholding tax under § 881(a) with respect to this income.

Criticism and Omitted Information
Both revenue rulings have been highly criticized by insurance companies and settlement providers. The primary area of criticism centers around the disparate treatment in the reduction of basis by the cost-of-insurance for insured individuals but not by life settlement investors.

With respect to investors, Rev. Rul. 2009-14 limits its holdings to term life insurance contracts and does not address the tax treatment of gain realized by an investor on the transfer of a permanent (non-term) insurance policy when the gain is wholly or partly attributable to investment income built-up inside the policy. The ruling implies that gains attributable to inside build up would be ordinary in character but does not specifically address this issue in the same manner as Rev. Rul. 2009-13 with respect to non-term life insurance contract gains realized by the insured policyholder. Rev. Rul. 2009-14 also fails to address the tax treatment of income from a sale of a life insurance contract by a foreign corporation to a U.S. third party.