Editor: Anthony S. Bakale, CPA, M. Tax.
On May 1, 2009, the IRS issued two revenue rulings discussing the taxation of life settlement transactions. Rev. Rul. 2009- 13 clarifies the tax implications of the surrender or sale of a life insurance policy by the original policyholder, while Rev. Rul. 2009-14 discusses the tax ramifications of certain transactions to an investor who has purchased a life insurance contract through a life settlement transaction. As the life settlement industry continues to grow, financial advisers should be aware of the tax implications of the transactions laid out in each revenue ruling.
Rev. Rul. 2009-13
Rev. Rul. 2009-13 presents the tax treatment of three common life insurance transactions: a taxpayer surrendering a whole-life insurance policy to the insurer for its cash surrender value, a taxpayer selling a whole-life insurance policy to an unrelated third party, and a taxpayer selling a term insurance policy to an unrelated third party who seeks to hold the policy for investment.
In situation 1, taxpayer A surrenders a policy to the insurer for its cash surrender value of $78,000. The cash surrender value reflects the total internal buildup of premiums paid to keep the policy in force and is net of a $10,000 cost of insurance protection provided by the insurer that allows A to enjoy the benefits of being insured. At the date of surrender, A had paid premiums on the policy totaling $64,000. As a result, A must recognize gain in the amount of $14,000. The IRS holds that this amount must be recognized as ordinary income based on Rev. Rul. 64-51, which states that “the proceeds received by an insured upon the surrender of, or at maturity of, a life insurance policy constitutes ordinary income to the extent such proceeds exceed the cost of the policy.” It is also important to note that Rev. Rul. 2009-13 specifically states that Sec. 1234A (which deals with the tax treatment of certain derivatives) does not apply.
Situation 2 has the same set of facts as situation 1, except that A sells the policy to an unrelated third party for $80,000 rather than surrendering it to the insurer. In this situation, the Service recognizes Congress’s position in the Code and holdings of the courts that a single life insurance contract can have both insurance and investment characteristics. For example, Rev. Rul. 2009-13 cites the opinion in Century Wood Preserving Co., 69 F.2d 967 (3d Cir. 1934), which states, “The policies of insurance involved here have a double aspect. They provide the present protection of ordinary life insurance and also a means of investment.” To determine A’s basis in the policy, an adjustment must be made to reduce the amount of premiums paid by the cost of insurance protection received. In this situation, A’s basis in the policy at the time of settlement is computed as $54,000 ($64,000 premiums paid less $10,000 internal cost of insurance). Total gain on the life settlement is $26,000 ($80,000 – $54,000).
In order to determine the character of the gain, the Service invokes the “substitute for ordinary income” doctrine from Midland Ross, 381 U.S. 54 (1965). Under this doctrine, a taxpayer cannot treat income recognized on the sale of an asset that would have produced ordinary income in the future as capital gain. Since the taxpayer would have recognized ordinary income of $14,000 on a normal surrender of the policy (see situation 1 above), he or she ordinarily must recognize ordinary income to the extent of the first $14,000 of gain realized. The remaining $12,000 is taxed as capital gain.
Finally, situation 3 addresses the tax implications of the sale of a term life insurance policy. In this situation, A sold the policy for $20,000 after holding it for 89.5 months. A had paid a monthly premium of $500 for 90 months. Absent any information to the contrary, the Service assumes that 100% of premiums are treated as cost of insurance, so A’s only basis in the contract is the unearned premium from the final one-half month, or $250. The gain of $19,750 is treated as capital because there is no ordinary income component to a term life insurance policy.
Rev. Rul. 2009-14
Rev. Rul. 2009-14 addresses the tax ramifications to an investor that has purchased a life insurance contract for profit. As in Rev. Rul. 2009-13, three situations are presented: a domestic taxpayer collecting death benefits on a life insurance policy upon an insured’s death, an investor’s sale of a life insurance policy to a separate third party unrelated to both the insured and the investor, and a foreign taxpayer collecting death benefits on a life insurance policy upon an insured’s death.
The first situation presents facts similar to situation 3 of Rev. Rul. 2009-13. Domestic taxpayer B purchases a term life insurance policy from individual A for $20,000. Prior to A’s death, B pays $9,000 of premiums to continue insurance on A. At A’s death, B collects $100,000 of benefits. Under Sec. 101(a)(2), the amount of proceeds excluded from B’s income cannot exceed the amount paid to purchase the policy from A plus additional premiums paid to keep the policy in force. As a result, the basis in the policy held by B is $29,000, so total gain recognized on collection of the death benefit will be $71,000. Since this is a surrender of life insurance upon death, the gain is taxed as ordinary income per Rev. Rul. 64-51.
Situation 2 includes the same facts as situation 1, except that B sells the policy to an unrelated third party for $30,000 prior to A’s death. As in situation 1, B’s basis is computed as $29,000, so gain upon sale is $1,000. The policy is considered to be held for investment and does not fall under the capital asset exceptions in Sec. 1221(a) or the ordinary income treatment of Rev. Rul. 64-51. As a result, the contract is treated as a capital asset and the gain associated with the sale is afforded capital gain treatment.
Finally, situation 3 applies the same facts as situation 1, except that taxpayer B is a foreign corporation not engaged in a trade or business in the United States. In this situation, A is a U.S. citizen residing in the United States and the insurer, IC, is a domestic corporation. Rev. Rul. 2009- 14 states that in the case of an income item’s source not being specified by statute or regulation, courts have generally determined that the source is determined by “comparison and analogy to classes of income specified within the statute.”
The Service then cites three Code sections to support the treatment of B’s receipt of income: Sec. 861(a)(1), which states that interest received by a domestic corporation is generally U.S. sourced; Sec. 861(a)(7), which states that premiums received on the insurance of the life of a U.S. resident are generally U.S. sourced; and Sec. 865, which holds that income from the sale of personal property is determined by reference to the taxpayer’s residence. Based on these three Code sections, the IRS holds that the proceeds at the time of A’s death will be treated as U.S. sourced because the income is analogous to the income described in the above Code sections for two reasons. First, premiums were paid to insure the life of a U.S. citizen residing in the United States, and, second, IC is a domestic corporation. In addition, unless a tax treaty is in place, domestic corporation IC will presumably be required to withhold a portion of the proceeds payable to B under income tax withholding provisions.
The Service makes several other important points in Rev. Rul. 2009-14. First, it notes that in situation 2 there was no inside buildup of cash value because this was a term policy, so the “substitute for ordinary income” doctrine does not apply.
Second, the Service points out that no deduction is allowed for the premiums paid to keep the insurance policy in force under Sec. 264. However, Sec. 1.263(a)-4(b)(1)(iv) allows the Service to publish guidance that “identifies a future benefit as an intangible for which capitalization is required.” Rev. Rul. 2009-14 further states that “[t]he 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.” The IRS is explicitly allowing capitalization of insurance premiums paid by an investor that acquired a life insurance contract on the secondary market for investment.
Finally, Rev. Rul. 2009-14 distinguished the treatment of an investor in a life insurance contract from the treatment of a person insured by a life insurance contract. In situation 2, B does not enjoy the benefits of being insured. Rather, B purchased the policy solely for investment and paid premiums solely to preserve its investment. Therefore, B is not required to reduce its basis in the life insurance policy by the cost of insurance benefits.
Rev. Ruls. 2009-13 and 2009-14 are in effect immediately, with the exception of situations 2 and 3 in Rev. Rul. 2009- 13. The IRS will apply the holdings of these situations to all applicable life settlement transactions entered into on or after August 26, 2009.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.