A presentation on the income tax consequences of the sales and surrenders of life insurance policies

1. Income Tax Consequences of
Sales and Surrenders of
Life Insurance Policies
A Presentation By:
J. Scot Kirkpatrick, Esq.
and
Rose K. Drupiewski, Esq.
June 16, 2010

2. Tax Code Provisions
The following Code provisions may affect
income taxation of life insurance policies.
§ IRC §61(a)(10) states that gross income includes income from life insurance.
§ IRC §101(a)(1) generally excludes from gross income all amounts paid by
reason of the death of the insured.
§ IRC §101(g) treats certain accelerated benefits received by terminally or
chronically ill insureds or amounts received on sale to a viatical settlement
provider as death benefits.
§ IRC §101(a)(2) contains an exception for a transfer for valuable
consideration: amount excluded equals the amount of the consideration plus
premiums subsequently paid.

3. Tax Code Provisions
§ IRC §72 contains rules for amounts received under an insurance policy other
than death proceeds.
§ Generally, such amounts are gross income only to the extent they exceed
the investment in the policy.
§ Proceeds from a policy loan are not treated as amounts received.
§ For Modified Endowment Contracts (“MECs”), income tax consequences
for all amounts received other than death proceeds are the same as for
annuities.

4. Tax Code Provisions
§ IRC §1035 provides for non-recognition of gain or loss on exchange of life
insurance policies for other policies or for endowment or annuity contracts (on the
same insured).
§ Starting in 2010, this also applies to exchanges for qualified long-term care
insurance.
§ Nonrecognition does not apply if endowment or annuity contracts are
exchanged for life insurance.
§ IRC §264 disallows a deduction for premiums paid if the payor owns the policy
or the payor or his beneficiaries can benefit from the policy.
§ Also limits deduction of interest paid on a policy loan or on debt incurred
to purchase or carry a policy.

5. Tax Code Provisions
§ IRC §165 governs whether a loss realized on sale, exchange or other disposition
of property can be deducted.
§ IRC §§ 1001 and 1011-1016 provide rules for determining the amount of gain or
loss on the sale, exchange or disposal of property, and for determining adjusted
basis of property.
§ IRC §§ 1221-1223 provide rules for determining if property is a capital asset.
§ IRC §§1222 defines a capital gain or loss as being realized from the sale or
exchange of a capital asset.
§ IRC §1234A is a special rule that characterizes gain or loss arising from
cancellation or termination of a right with respect to a capital asset as a capital
gain or loss.

6. Sales and Surrenders of
Policies at a Gain
In May 2009, the IRS issued two Revenue Rulings dealing with income tax
consequences when life insurance policies are surrendered or sold at a gain.
§ Rev. Rul. 2009-13: Deals with the income tax consequences to the insured
on sale or surrender of a policy at a gain.
§ Only applies to sales made after August 25, 2009.
§ Rev. Rul. 2009-14: Deals with the tax consequences to the investor and
purchaser on sale of a policy at a gain.
§ Both Rulings mention cash-value contracts and term contracts.

7. Revenue Ruling 2009-13
Surrender of Policy by the Insured
§ Tax treatment governed by IRC §72(e).
§ Gross income = excess of the amount received over investment in the policy.
§ Investment in the policy = total premiums paid.
§ Gross income is ordinary income.
§ IRC §1234A does not apply.
§ Surrender by a non-insured original owner or owner who is donee of a policy
from the insured will generally receive the same treatment.

8. Revenue Ruling 2009-13
Surrender of Policy: Facts and Holding
§ Facts:
§ Insured was not terminally or chronically ill for purposes of §101(g).
§ Insured owned the policy for 15 years.
§ Policy was not a MEC.
§ Total paid premiums of $64,000, cash surrender value $78,000 (after
subtracting $10,000 cost of insurance charges).
§ Holding:
§ Gross income = $14,000.
§ All ordinary income.

9. Revenue Ruling 2009-13
Sale of Policy by the Insured
§ Tax treatment governed by IRC §1001.
§ Gross income = amount realized - adjusted basis.
§ Adjusted basis = premiums paid - cost of insurance.
§ No explanation as to how cost of insurance is determined.
§ Under the “substitute for ordinary income doctrine”, gain is ordinary income to
the extent ordinary income would have resulted on surrender.
§ Balance of the gain is capital gain.

10. Revenue Ruling 2009-13
Sale of Permanent Policy: Facts and Holding
§ Facts:
§ Insured was not terminally or chronically ill for purposes of §101(g).
§ Insured owned the policy for 15 years.
§ Policy was not a MEC.
§ Insured paid premiums of $64,000, the cost of insurance was $10,000, cash
surrender value was $78,000, and upon sale insured received $80,000.
§ Holding:
§ Adjusted basis = $54,000.
§ Gain realized = $26,000.
§ Ordinary income of $14,000; long-term capital gain of $12,000.

11. Revenue Ruling 2009-13
Sale of Term Policy: Facts and Holding
§ Facts:
§ Insured held a $500/month 15-year level premium term policy.
§ Insured paid premiums of $45,000.
§ Insured sold the policy on June 15 of Year 8, and upon sale of the policy
received $20,000.
§ Holding:
§ Cost of insurance is assumed to equal premiums.
§ Adjusted basis = $250 ($45,000 - $44,750).
§ Gain realized = $19,750.
§ Gain is long-term capital gain.

12. Revenue Ruling 2009-14
Death of the Insured Following Sale
§ Tax treatment governed by IRC §101.
§ Gross income = proceeds - investment in the policy.
§ Investment = purchase price + additional premiums paid.
§ Gross income is ordinary income.

13. Revenue Ruling 2009-14
Insured’s Death: Facts and Holding
§ Facts:
§ Investor purchased a 15-year level premium ($500 monthly) term policy with
7 years, 6 months, and 15 days remaining for $20,000.
§ Investor had no relationship to insured and would suffer no economic loss
upon insured’s death.
§ Insured died and investor received $100,000 under the contract.
§ Investor had paid premiums totaling $9,000.
§ Holding:
§ Investment in the policy = $20,000 + $9,000.
§ Gain realized = $71,000, all ordinary income.

14. Revenue Ruling 2009-14
Resale of Policy from Investor to Investor
§ Tax treatment governed by IRC §1001.
§ Seller’s gross income = gain on the sale
§ Gain = sale price – adjusted basis of the policy
§ Adjusted basis = purchase price + additional premiums paid
§ Gain is capital gain if the policy is a capital asset
§ Unlike the insured seller, no basis reduction for cost of insurance charges.
§ Rationale: an investor purchases a policy solely with a view to profit, thus all
payments to keep the policy relate to an investment.
§ The Service will not challenge premiums capitalized prior to issuance of the
Ruling.

15. Revenue Ruling 2009-14
Resale of Policy: Facts and Holding
§ Facts:
§ Investor purchased a 15-year level premium ($500 monthly) term policy with
7 years, 6 months, and 15 days remaining for $20,000.
§ Investor had no relationship to insured and would suffer no economic loss
upon insured’s death.
§ Investor sold the policy for $30,000.
§ Investor had paid premiums totaling $9,000.
§ Holding:
§ Adjusted basis = $20,000 + $9,000.
§ Gain realized = $1,000, long-term capital gain.

16. Sales and Surrenders of
Policies at a Loss
Surrender of Policy at a Loss
§ A number of cases have held that even if the policy is held in a trade or business
or as an investment, the loss upon surrender is not deductible.
§ Loss upon surrender represents unrecovered premium payments, which are
not deductible under IRC §264.
§ However, if the insurance company is insolvent so recovery of cash value is
impossible, a loss should be deductible to the extent of cash surrender value over
amount received.
§ This loss should be an ordinary loss because a surrender is not a sale or
exchange of a capital asset.

17. Sales and Surrenders of
Policies at a Loss
Sale of Policy at a Loss by Business or Investor
§ If a policy is held in a trade or business or for investment, loss deduction should
be allowed upon sale.
§ PLR 200945032: Loss = surrender proceeds – adjusted basis
§ Adjusted basis must be reduced for cost of insurance charges and mortality
charges.
§ Therefore, loss may be disallowed to the extent it results from a failure to
recover additional premiums paid that do not increase the policy’s cash value.
§ Deductible losses are capital losses if the policy is a capital asset.

18. Sales and Surrenders of
Policies at a Loss
Sale of Policy at a Loss by Insured
§ Losses on personal use property are not deductible.
§ An IRC §1035 exchange may be a better solution.
§ Loss on the exchange is not deductible, but investment in the new policy
should include premiums paid on the old policy if the new policy is later
surrendered.

19. Policy Loans Upon
Sales and Surrenders
Policy Loans in General
§ If a policy owner takes a loan against a policy (which is not a MEC), there are no
income tax consequences.
§ Loan proceeds are not income.
§ The loan does not reduce the policy owner’s investment in the policy.

20. Policy Loans Upon
Sales and Surrenders
Surrender of Policy Where Loan is Paid Off on Surrender
§ Amount realized = cash received by the policy owner + loan amount
§ Gross income = amount realized – investment in the policy
§ Barr v. Commissioner, T.C. Memo 2009-250
§ Policy owner borrowed $350,000 against a policy having cash value of
$361,000 and premiums paid of $225,000.
§ Insurance company terminated the policy when owner declined to pay
premiums or reduce the loan.
§ Owner received a check for $11,000.
§ Owner’s gross income on surrender was ($350,000 + $11,000) - $225,000 =
$136,000.

21. Policy Loans Upon
Sales and Surrenders
Sale of Policy Where Loan is Relieved on Sale
§ Under the “substitute for ordinary income doctrine”, gain is ordinary income to
the extent ordinary income would have resulted on surrender.
§ Balance of the gain is capital gain.
§ Gross income = amount realized – adjusted basis in the policy
§ Amount realized = cash received by the policy owner + loan amount
§ Adjusted basis = premiums paid - cost of insurance

22. Policy Loans Upon
Sales and Surrenders
Sale of Policy Where Loan is Relieved on Sale
§ Example:
§ A’s policy has cash value of $100,000 and an outstanding loan of $85,000.
§ A has paid total premiums of $60,000 and cost of insurance is $20,000.
§ A sells the policy to an investor for $30,000 subject to the loan.
§ Amount realized = $30,000 + $85,000 = $115,000
§ Gain = $115,000 – ($60,000 - $20,000) = $75,000
§ $40,000 is ordinary income and $30,000 is capital gain.

23. Policy Loans Upon Gift of Policy
Gift of Policy Where Loan is Paid by Donee or Donee Takes Subject to Loan
§ If a donee of a policy pays off a policy loan or takes a policy subject to a loan,
there may be income tax consequences to the donor.
§ Example:
§ A’s policy has cash value of $100,000 and carries a loan of $85,000.
§ Total premiums paid is $60,000 and cost of insurance is $20,000.
§ A gives the policy to his son subject to the loan.
§ A has taxable gain because he is deemed to have sold the policy to his son
for $85,000.
§ Gain is $85,000 less basis of $40,000 ($60,000 - $20,000) = $45,000.
§ A has ordinary income of $40,000 and capital gain of $5,000.

24. Estate Planning Transfers
of Life Insurance
Gift of Policy to ILIT
§ In the previous example, if A had given the policy to an ILIT for the benefit of his
son, the outcome would have been more favorable.
§ Example:
§ A’s policy has cash value of $100,000 and carries a loan of $85,000.
§ Total premiums paid is $60,000 and cost of insurance is $20,000.
§ A gives the policy to an ILIT to benefit his son.
§ An ILIT is a grantor trust for income tax purposes.
§ No gain is recognized by A on the transfer of the loan obligation to the ILIT.

25. Estate Planning Transfers
of Life Insurance
Sale of Policy to ILIT
§ In a transfer for value, the purchaser may only exclude from gross income the price
paid + additional premiums paid when death benefits are paid.
§ Solution: Sell the policy to an ILIT.
§ ILIT is a grantor trust so there is no tax on sale.
§ Grantor may make cash gifts to fund premium payments or pay off policy loan.
§ Sale removes IRC §2035 risk.
§ Avoids the transfer for value rule under the exception where the purchaser’s
basis in the policy is determined with reference to the seller’s basis.