IRS provides guidance on taxation of life insurance policy surrenders, sales and purchases

Situation: Your client is considering either a surrender or sale of a life insurance policy and asks about the income tax consequences.

Solution: Life settlements have become increasingly popular in the past few years. Until now, there was no official Internal Revenue Service guidance about the tax treatment of these sales. However, even though the guidance is welcome, it does not cover every circumstance.

Revenue Rulings 2009-13 and 2009-14 addressed the income tax treatment relating to a surrender, sale and purchase of life insurance policies. Ruling 2009-13 applies to an individual who either surrenders or sells a life insurance policy, and Ruling 2009-14 addresses the tax implications to the buyer.

Revenue Ruling 2009-13
In Situation 1 of Revenue Ruling 2009-13, the individual surrenders a policy with a cash value of $78,000 in which prior premiums totaled $64,000. In this circumstance, he or she will recognize income equal to the difference of the cash value and the investment in the contract. Investment in the contract will be the total amount of premiums paid. Therefore, the individual will recognize income of $14,000. This income will be taxed at the ordinary income tax rates.

In Situation 2, the individual sells the policy to a third party, in a life settlement transaction, for $80,000. In this case, the income is measured by comparing the sale proceeds to basis in the contract. Basis must be reduced by “that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.” Therefore, total premiums of $64,000 are reduced by the cost of insurance, which in this example is $10,000.

The individual will recognize income of $26,000, which is equal to the difference of the sale proceeds and basis. This income is characterized as ordinary income to the extent the cash value exceeds total premiums ($14,000). The balance ($12,000) will be treated as a capital gain.

Situation 3 involves the sale of a level-term policy in a life-settlement transaction for $20,000. The individual paid monthly premiums totaling $45,000 prior to the sale. Basis is determined in the same fashion as Situation 2. In the case of term insurance in this example, “absent other proof, the cost of the insurance … is presumed to equal the monthly premium under the contract, or $500.” Therefore, basis equals zero or a modest amount equal to the prepaid premium. In Situation 3, basis was deemed to be $250, representing the prepaid premium for the half of the month that had not expired.

The difference between the sale price and basis is a capital gain. Therefore, the individual would report a capital gain of $19,750. Since the policy was held more than 12 months, the gain is long term.

Revenue Ruling 2009-14
Ruling 2009-14 addresses the income-tax consequences to the purchaser of a term life insurance policy upon later maturity of the contract or sale. If the purchaser collects the death benefit from the policy (i.e., the policy matures), ordinary income is recognized to the extent the death benefit exceeds basis. Basis will include the purchase price of the policy as well as subsequent premium payments.

Normally death benefits are not taxable; however, the purchaser of a policy in a life-settlement transaction generally will be deemed to be a party of a “transfer for value.” Thus, the proceeds, less basis, will be taxable. If the purchaser sold the policy prior to maturity, the sale price in excess of basis would be treated as a capital gain (Situation 2 of Ruling 2009-14).

Unfortunately, these revenue rulings leave open questions and will require the insurance carrier to provide additional information to the policyholder upon sale of the contract. For example, Ruling 2009-14 only addresses the purchase of a term life insurance policy. Would the tax results differ with a cash value policy? How is the cost of insurance determined? Do we look to the split-dollar rules? If so, do we apply the old rules, which look at the insurance carrier’s one-year term rates? The new rules reference a table issued by the IRS and generally are less favorable for the individual.

We will have to look forward to further clarification in the future. In the meantime, at least we have some guidance as to the IRS’s tax position.