SALE OR SURRENDER OF LIFE INSURANCE CONTRACTS

In today’s difficult financial times, more taxpayers than usual are cashing in or selling their life insurance policies. A recent Revenue Ruling addresses the IRS’ view of the income tax consequences of such transactions. The salient points are summarized below. Note that these rules apply to non-modified endowment policies (non-MEC) policies – results can differ for MEC policies.

A. SURRENDER OF POLICY TO THE INSURANCE COMPANY. In this circumstance the policy holder has income if and to the extent that the amount received on surrender exceeds his or her “investment in the contract.” Section 72(e)(5). The “investment in the contract” is the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income. It is the position of the IRS that any such income is ordinary income, and not capital gain.

B. SALE OF INSURANCE POLICY. While seemingly the same economic transaction occurs in a sale as under a surrender, different tax results obtain because a sale is taxed under the sale or exchange provisions of the Code, including Section 1001, while the above surrender treatment is addressed under the insurance – annuity rules of Section 72. In the case of a sale of a policy, the seller incurs a gain to the extent that the amount received exceeds his or her adjusted basis in the contract. Note that “adjusted basis” is not the same as “investment in the contract,” although premium payments are credited towards both. A key difference is that to the extent premium payments are allocable strictly to the cost of life insurance (and not the build-up of cash value to pay future premiums or benefits), that portion of the premium payment reduces basis, and will thus increase gain (or reduce loss) on the sale. In the case of a sale of term life insurance, the monthly premium amount is treated as the cost of life insurance through the date of sale. Not all practitioners are willing to concede that such a reduction in basis is proper. Notwithstanding sale or exchange treatment under Section 1001, the IRS nonetheless applies the “substitute for ordinary income” doctrine to tax the gain as ordinary income and not capital gain, to the extent the sales price is attributable to the inside build-up in the contract, with any remaining portion of the gain eligible for capital gain treatment.

Rev. Rul. 2009-13, 2009-21 IRB