Guidance on Sales and Purchases of Life Insurance Contracts

By Alistair M. Nevius, J.D.

On May 1, the IRS released two revenue rulings that provide guidance for sellers and purchasers of life insurance contracts (Rev. Ruls. 2009-13 and 2009-14).

Rev. Rul. 2009-13 addresses policyholders who sell or surrender their life insurance contract. The ruling addresses three situations in which an individual enters into a cash-value life insurance contract under which the individual is the insured and a family member is the named beneficiary. In the first situation, the individual surrenders the contract for its cash surrender value. In the second and third situations, the individual sells the contract to an unrelated person.

In the first instance, the individual must recognize income to the extent the amount received exceeds the investment in the contract. The ruling specifies that this is characterized as ordinary income, not capital gain.

In the second situation, the individual recognizes income to the extent the amount realized in the sale exceeds the individual’s basis in the contract. The ruling applies the “substitute for ordinary income” doctrine to hold that the amount realized, up to the amount of the contract’s inside buildup, is ordinary income, and the amount realized that exceeds the inside buildup is capital gain. The inside buildup equals the cash surrender value minus the aggregate premiums paid on the contract.

The third situation posits that there is no cash surrender value on the contract, so there is no inside buildup and the entire amount realized will be characterized as capital gain.

Rev. Rul. 2009-14 gives guidance to investors who purchase a life insurance contract. The ruling addresses three situations in which a U.S. citizen purchases a life insurance contract and then receives death benefits or sale proceeds from the life insurance. The ruling says that in these situations the individual must recognize ordinary income when receiving death benefits and must recognize long-term capital gain when selling the contract.

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