Income from Sales or Settlements of Life Insurance Contracts

By Dawn M. Beatty, CPA, EEPB, P.C., Houston, TX

Editor: Stephen E. Aponte, CPA

Life insurance contracts have a plethora of tax complexities with varying tax implications. In Rev. Rul. 2009-13, the IRS has provided guidance on the amount and character of income that taxpayers recognize in the surrender or sale of life insurance contracts. In Rev. Rul. 2009- 14, the IRS has provided guidance to purchasers of life insurance contracts for profit. Life insurance contracts have long been in existence, but the Code did not define them for tax purposes until Sec. 7702 was added in 1984 by the Deficit Reduction Act of 1984, P.L. 98-369, effective for co ntracts issued after December 31, 1984, in tax years ending after December 31, 1984.

Life insurance contracts have a plethora of tax complexities with varying tax implications. In Rev. Rul. 2009-13, the IRS has provided guidance on the amount and character of income that taxpayers recognize in the surrender or sale of life insurance contracts. In Rev. Rul. 2009-14, the IRS has provided guidance to purchasers of life insurance contracts for profit. Life insurance contracts have long been in existence, but the Code did not define them for tax purposes until Sec. 7702 was added in 1984 by the Deficit Reduction Act of 1984, P.L. 98-369, effective for co ntracts issued after December 31, 1984, in tax years ending after December 31, 1984.

Life Insurance Contract Defined

The term “life insurance contract” as defined in Sec. 7702 means any contract that is a life insurance contract under the applicable law, but only if the contract:

  • Meets the cash value accumulation test of Sec. 7702(b); or
  • Meets the guideline premium requirements of Sec. 7702(c) and falls within the cash value corridor of Sec. 7702(d).

Cash value accumulation test: A contract meets the cash value accumulation test if, by the terms of the contract, the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at that time to fund future benefits under the contract.

Guideline premium requirements: A contract meets the guideline premium requirements if the sum of the premiums paid under the contract does not at any time exceed the guideline premium limitation as of that time.

Cash value corridor: A contract falls within the cash value corridor if the death benefit under the contract at any time is not less than the applicable percentage of the cash surrender value. Additional information regarding the cash valuation accumulation test, guideline premium requirements, and the cash value corridor can be found in Sec. 7702 and its regulations.

Taxation If Contract Meets Definition and Insured Dies

If the contract meets the life insurance contract definition, Sec. 101(a) provides that amounts received are generally excluded from gross income if paid by reason of the death of the insured. The exclusion under Sec. 101(a) applies regardless of whether the payment is made to the estate of the insured or to an individua l, corporation, partnership, or other beneficiary and whether it is made directly or in trust.

Taxation If Contract Does Not Meet Definition

If a contract does not meet the life insurance contract definition, in general the income on the contract for any tax year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during that year (Sec. 7702(g)(1)). The term “income on the contract” means, with respect to any tax year of the policyholder, the excess of:

  • The sum of the increase in the net surrender value of the contract during the tax year and the cost of life insurance protection provided under the contract during the tax year, over
  • The premiums paid under the contract during the tax year.

Life Insurance Contracts Sold and Purchased in the Secondary Market

Life insurance contracts purchased by the insured are not always held until death. The IRS issued guidance in Rev. Rul. 2009- 13 on the amount and character of income to be recognized involving the surrender or sale of a life insurance contract that meets the definitional requirements of Sec. 7702. The guidance is provided through three different factual situations.

Situation 1—Surrender for cash surrender value: A, an individual, entered into a life insurance contract with cash value. Under the contract, A was the insured, and the named beneficiary was a member of A’s family. A had the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value. The contract in A’s hands was not property described in Sec s. 1221(a)(1)–(8) (i.e., it was a capital asset).

A surrenders the contract for its $78,000 cash surrender value, which reflects the subtraction of $10,000 of “cost of insurance” charges collected by the issuer for periods ending on or before the surrender date. Through that date, A had paid $64,000 in premiums under the life insurance contract. A never received any distributions under the contract and never borrowed against the contract’s cash surrender value.

In general, under Sec . 72(e)(2), a nonannuity amount that is received on or after the annuity starting date is included in gross income, but only to the extent it exceeds investment in the contract. Sec. 72(e) does not specify whether income recognized on the surrender of a life insurance contract is treated as ordinary income or as capital gain. The life insurance contract is capital asset property. However, Rev. Rul. 64-51 explicitly states that the proceeds received from the surrender of, or at the maturity of, a life insurance contract are ordinary income to the extent that they exceed the cost of the policy. Accordingly, the $14,000 of income recognized by A on the surrender of the life insurance contract is ordinary income.

Situation 2—Sale of cash value life insurance contract: The facts are the same as in situation 1, except that A sells the life insurance contract for $80,000 to B, a person unrelated to A who would suffer no economic loss upon A’s death.

Unlike situation 1, which involves the surrender of the life insurance contract to the issuer of the contract, situation 2 involves an actual sale of the contract. Nevertheless, some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.

The Supreme Court has held, under the substitute for ordinary income doctrine, that cla ims or rights to ordinary income are not capital assets (United States v. Midland-Ross Corp., 381 U.S. 54 (1965)). Claims or rights to ordinary income include lump-sum payments attributable to income from or accretions to the value of capital assets that otherwise would have been ordinary income when recognized in the future by the taxpayer (Prebola, 482 F.3d 610 (2d Cir. 2007)). Thus, ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange.

The inside buildup under A’s life insurance contract immediately prior to the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). If B had surrendered the life insurance contract or held it to maturity, this inside buildup would have been taxed as ordinary income per Rev. Rul. 64-51. Hence, $14,000 of the $26,000 of income that A must recognize on the sale of the contract is ordinary income under the substitute for ordinary income doctrine. The remaining $12,000 of income is longterm capital gain within the meaning of Sec . 1222(3).

Situation 3—Sale of term (no cash value) life insurance contract: The facts are the same as in situation 1, except that the contract was a level premium 15-year term life insurance contract without cash surrender value. A paid premiums totaling $45,000 and then sold the life insurance contract for $20,000 to B, a person unrelated to A who would suffer no economic loss upon A’s death.

A’s adjusted basis in the life insurance contract for purposes of determining gain or loss on the sale equals the total premiums paid under the contract less charges for the provision of insurance before the sale. Absent other proof, the cost of the insurance provided to A each month is presumed to equal the monthly premium under the contract (in this case, $500). The cost of the insurance protection provided to A during the 89½ months that A held the contract was $500 × 89½ months, or $44,750. Hence, A’s adjusted basis in the contract on the date of the sale to B was $250 ($45,000 total premiums paid less $44,750 cost of insurance protection).

The life insurance contract was a capital asset under Sec. 1221(a), and B held it for more than one year. The term life insurance contract had no cash surrender value. Hence, there was no inside buildup under the contract to which the substitute for ordinary income doctrine could apply. Therefore, the $19,750 of inc ome that A must recognize on the sale of the contract is long-term capital gain within the meaning of Sec. 12 22(3).

Effective date: Rev. Ru l. 2009-13 is effective immediately, but the holdings with respect to situations 2 and 3 will not be applied adversely to sales occurring before August 26, 2009.

Purchases of Life Insurance Contracts at Profit

Rev. Rul. 2009-14 provides guidance on the amount and character of income to be recognized by purchasers of life insurance contracts at profit from a U.S. citizen. Consistent with Rev. Rul. 2009- 13, the guidance pertains to life insurance contracts that meet the definitional requirements of Sec. 7702. Three different factual situations are presented.

Situation 1—Payment of death benefit: A and B are U.S. citizens residing in the United States. B purchases from A for $20,000 a life insurance contract on A’s life. The contract was a level premium 15- year term life insurance contract without cash surrender value. As owner of the contract, B has the right to change the beneficiary and, pursuant to that right, names himself beneficiary under the contract immediately after acquiring the contract.

B had no insurable interest in A’s life (except for the purchase of the contract), had no relationship to A, and would suffer no economic loss upon A’s death. B purchased the contract with a view to profit. The contract in B’s hands was not capital asset property described in Secs. 1 221(a)(1)–(8). The likelihood that B would allow the contract to lapse by failing to pay any of the remaining premiums was remote.

On December 31, 2009, A died, and IC, the domestic corporation insurer, paid $100,000 under the life insurance contract to B by reason of A’s death. Through that date, B had paid monthly premiums totaling $9,000 to keep the contract in force.

While generally gross income does not include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured, in the case of a transfer for valuable consideration, Sec. 10 1(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 paid and the premiums and other amounts subsequently paid by the transferee. This “transfer for value” rule does not apply in the case of a tr ansfer involving a carryover basis or in the case of a transfer to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or an officer.

B received $100,000 from IC by reason of the death of A, the insured under the contract. Because B purchased the contract from A in exchange for a purchase price of $20,000, B’s acquisition of the contract was a “transfer for a valuable consideration” within the meaning of Sec. 10 1(a)(2). Neither the carryover basis exception of Sec. 10 1(a)(2)(A) nor the exception for transfers involving parties related to the insured under Sec. 10 1(a) (2)(B) applied. Accordingly, Sec. 10 1(a) (1) excludes from B’s gross income the amount received by reason of A’s death, but Sec. 10 1(a)(2) limits the exclusion to the sum of the actual value of the consideration paid for the transfer ($20,000) and other amounts paid by B ($9,000), or $29,000. B therefore must include in gross income $71,000, which is the difference between the total death benefit received ($100,000) and the amount excluded under Sec. 10 1 ($29,000).

The life insurance contract was property held by B not described in Secs. 1221(a)(1)–(8), so it is a capital asset. However, neither the surrender of a life insurance or annuity contract nor the receipt of a death benefit from the issuer under the terms of the contract produces a capital gain. Therefore, the $71,000 income B recognized upon the receipt of death benefits under the contract is ordinary income.

Situation 2—Investor sells policy: The facts are the same as in situation 1, except that A does not die and on December 31, 2009, B sells the contract to C (a person unrelated to A or B) for $30,000.

Under Sec. 1001(b), B’s amount realized from the s ale of the life insurance contract is the sum of money received from the sale, or $30,000. Regs. Sec. 1.263(a)-4(c)(1)(iv) requires taxpayers to capitalize an amount paid to another party to acquire an intangible (including a life insurance contract) from that party in a purchase or similar transaction. B paid $20,000 to A to acquire the life insurance contract from A, which is included in B’s cost basis. B also paid $9,000 in monthly premiums to prevent the contract from lapsing. No deduction is allowed for these monthly premiums under Sec. 264.

Regs. Sec. 1.263(a)-4(b)(1)(iv) authorizes the Service and Treasury to publish guidance that identifies a future benefit as an intangible for which capitalization is required. The premiums paid by a secondary market purchaser of a term life insurance contract serve to create or enhance a future benefit for which capitalization is appropriate. Accordingly, Rev. Rul. 2009-14 requires a secondary market purchaser to capitalize premiums paid to prevent a term life insurance contract (without cash value) from lapsing. However, the Service will not challenge the capitalization of such premiums paid or incurred prior to the issuance of this ruling.

Therefore, B’s adjusted basis for purposes of measuring gain on the sale to C was $29,000. Because the amount realized on B’s sale of the life insurance contract to C was $30,000 and the adjusted basis was $29,000, B must recognize $1,000 on the sale to C. The life insurance contract was property held by t he taxpayer not described in Secs. 1221(a) (1)–(8) so it is a capital asset. In addition, the contract was a term contract without any cash value, so there was no buildup inside the contract. Hence, the substitute for ordinary income doctrine under Midland- Ross does not apply, and the $1,000 of gain recognized b y B on the sale of the contract to C is long-term capital gain.

Observation: In the second situation described in Rev. Rul. 2009-13, the taxpayer was required to deduct “cost of insurance” charges from his basis in the policy because he had received the benefit of insurance coverage. However, in this case B, who is totally unrelated to A, purchased the insurance contract as an investment, paid the policy premiums purely to prevent the loss of the investment, and received no insurance coverage for his premium payments. Therefore, B is not required to reduce his basis in the policy by any cost of insurance charges.

Situation 3—Foreign investor: The facts are the same as in situation 1, except that B is a foreign corporation that is not engaged in a trade or business within the United States (including the trade or business of purchasing, or taking assignments of, life insurance contracts). As in situation 1, B must recognize $71,000 of ordinary income upon the receipt of death benefits. This income is “fixed or determinable annual or periodical” income within the meaning of Sec. 881(a)(1). (See Regs. Sec. 1.1441-2(b); Rev. Rul. 64-51; and Rev. Rul. 2004-75.) Consequently, B is subject to tax under Sec. 881(a) with respect to this income if the inc ome is from sources within the United States. In the current situation, A is a U.S. citizen residing in the United States, and the issuing insurance company is a domestic corporation. B’s income is from sources within the United States.

Conclusion

As demonstrated by Rev. Ruls. 2009-13 and 2009-14, the purchase and disposition of a life insurance contract may require the taxpayer and his or her adviser to analyze a multitude of Code sections to determine the amount of income to be recognized and the character of that income—which may render unanticipated results. Proper analysis and planning are therefore critical to avoid unfavorable outcomes.


EditorNotes

Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.

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